Bond market participants returning from the three-day weekend were greeted by news of potential progress in Washington. As of Tuesday morning, however, no real compromise has yet to emerge and there are now reports of competing proposals coming out of the House and the Senate. Our guess is that nothing will get accomplished until the very last possible minute before the debt ceiling kicks in on Thursday, October 17th. Until then, the global financial markets will just have to hang on by their collective fingernails.
Based on just a modicum of optimism, the yields on the benchmark 10-year and 30-year Treasury have crept up slightly to 2.71% and 3.77%, respectively. The Treasury yield curve inside of 6 months remains inverted as money market participants try their best to reduce their exposure to a potential government default scenario. As a sign of rising nervousness on the part of the capital markets, this morning’s auctions of 3-month and 6-month T-bills were met with rather tepid demand.
New Issue Market
The muni new issue calendar for this holiday-shortened week is estimated at just over $4 billion, as many would-be issuers prefer to wait out the results of the debt ceiling debate. Apparently, New York issuers don’t share the same squeamishness: the leading negotiated deals will include a $956 million sales tax revenue offering from the State of New York Dormitory Authority and $360 million senior revenue notes from the Battery Park City Authority.
In the absence of any real direction, market participants remain intensely focused on the performance of the Puerto Rico sector and its potential impact on mutual fund flows. The Standard & Poor’s Municipal Bond Puerto Rico index is already down 6.07% for the month to date and nearly 21.50% for the year to date.
Puerto Rico Update
Since May, the stock prices of the two publicly-traded bond insurers – Assured Guaranty (AGO) and MBIA (MBI) – have been taking a hit over concerns about their potential Detroit and Puerto Rico (PR) exposures. Investors have been fretting about the companies’ ability to absorb any potential claim from those two credit disasters, as well as any potential increase in capital charges should PR get downgraded to below-investment grade. In our August 20th column, we also discussed the bond insurers’ exposure to the current credit trouble spots in the tax-exempt market. AGO and MBI are both trading down, -24% and -36%, respectively, from their 52-week high.
Between now and year-end, barring a significant rebound in [Puerto Rico’s] economic indicators, the next shoe to drop could be a downgrade to below-investment grade by at least one of the rating agencies.
Yesterday, Standard & Poor’s confirmed both firms’ capital adequacy under either a PR downgrade or default scenario. According to S&P’s analysis, a downgrade of Puerto Rico from ’BBB’ to ’BB’ would result in a capital charge for each of the two insurers of approximately $65 million. A further downgrade to ’B’ would translate into a capital charge for each of approximately $115 million. According to S&P, Assured has a capital cushion of $450 million to $500 million against exposure of $5.5 billion and MBIA’s National Public Finance Guarantee Corp. has $350 million to $400 million versus exposure of $5.3 billion.
Incidentally, AMBAC also released a detailed update and analysis of its PR exposure. Interested readers may find it here.
This does bring up the whole issue of why PR’s G.O. rating has remained investment-grade in the first place. Based on current trading levels, the market seems to view it as a “B” credit at best, if not lower. Between now and year-end, barring a significant rebound in PR’s economic indicators, the next shoe to drop could be a downgrade to below-investment grade by at least one of the rating agencies. While logic would dictate that such a downgrade is already reflected in current yield levels, another negative knee-jerk reaction by retail investors cannot be ruled out. The Efficient Markets Hypothesis spearheaded by my old professor and Nobel Prize winner Gene Fama could never apply to munis!
Incidentally, we don’t believe a downgrade will, in and of itself, bring additional institutional selling pressure. By prospectus, most mutual funds do have the ability to continue to hold below-investment grade paper that was purchased initially as investment grade. We worry more about the fact that a rating drop may lead to higher cash collateral requirements for the Commonwealth’s interest rate swaps, something the island can ill afford at this time.
In the meantime, the Padilla Administration is putting together a concerted effort to tell its side of the story, starting with an investor webcast scheduled for this afternoon. We, along with many others, will be on the call and will report back to you with any new information.
Detroit Takes Another DIP in the Restructuring Pool
Today marks the beginning of what could turn into months of hearings regarding Detroit’s eligibility to file for bankruptcy. U.S. Bankruptcy Judge Steven Rhodes will start off with two days of hearings on legal issues surrounding the filing.
In the meantime, the City continues to break new legal ground by using restructuring techniques heretofore used only in the corporate arena. Late last week, the Emergency Manager team announced it was able to obtain a $350 million Debtor-In-Possession (“DIP”) financing from Barclays Bank.
Here’s the rub: there is no real legal precedent under Chapter 9 for a DIP loan, and many experts still question whether it’s even legally enforceable. According to Reuters, “there is no blueprint for determining the collateral the city can pledge, and how much power the judge has to enforce a lender’s rights if Detroit defaults.” Typically, in corporate bankruptcies, DIP loans are used to as a way to control a restructuring, so it’s not clear what additional role Barclays will be playing in the bankruptcy proceedings going forward.
Here’s the rub: there is no real legal precedent under Chapter 9 for a DIP loan, and many experts still question whether it’s even legally enforceable.
The loan will be structured as financial recovery bonds with a 2.5 year maturity, backed by a pledge of the city’s income taxes as well as casino revenues (once they’re released as collateral on the interest rate swaps) and any proceeds over $10 million that come from the privatization of any city asset. For the privilege, Detroit will pay Barclays LIBOR plus 2.5%, with a 3.5% effective floor. This certainly represents a hefty premium over the 2-year Treasury yield, which closed yesterday at a mere 0.35%.
Our initial reaction to this novel but untested financing is that it may further subordinate the claims of unsecured creditors, including the G.O. bonds and pension liabilities. In fact, “Barclays will be given a claim on the borrowing that has priority over all administrative expense claims, all other post-petition claims, and pre-petition unsecured claims,” according to the City.
Needless to say, the deal is conditional upon Detroit being eligible to file for Chapter 9 and upon successful termination of the city’s interest rate swaps. Neither of these hurdles will be easily overcome. For instance, the proposed settlement for the swaps is being vigorously opposed by bond insurer Syncora.
About $230 million of the DIP proceeds will be used to terminate the swaps, with the balance earmarked for general city improvement projects. It’s ironic that Kevyn Orr is so anxious to get a release of the casino revenues that he’s willing to turn a “soft” liability (i.e. the swaps) into a hard-dollar settlement with the banks, at a time in the interest rate cycle when those swap liabilities could actually start to decline.
Between the DIP financing for Detroit and the recent short-term private placement for Puerto Rico, Barclays is certainly making a big bet on two of the biggest credit issues currently facing the muni market. Here’s hoping the bank’s gamble pays off.
Disclaimer: The opinions and statements expressed in this column are solely those of the author and Axios Advisors, who are solely responsible for the accuracy and completeness of this column. This column does not reflect the position or views of RICIC, LLC or MuniNetGuide.
The opinions and statements expressed on this website are for informational purposes only, and are not intended to provide investment advice or guidance in any way and do not represent a solicitation to buy, sell or hold any of the securities mentioned. Opinions and statements expressed reflect only the view or judgment of the author(s) at the time of publication, and are subject to change without notice. Information has been derived from sources deemed to be reliable, but the reliability of which is not guaranteed. Readers are encouraged to obtain official statements and other disclosure documents on their own and/or to consult with their own investment professional and advisors prior to making any investment decisions.