As expected, the dramatic events in Washington did go down to the wire on Wednesday, and we still ended up with no permanent solution. Although a default on the national debt may have been averted, our politicians’ decision to kick the can down the road yet again may have inflicted great damage to the near-term economic outlook. The cloud of sure-to-be contentious budget negotiations and the fear of another government shutdown in another three months will hang over the economy at least through year-end, and probably until Janet Yellen’s first FOMC meeting. And, barring an unexpected surge in employment over the next few months, we can just forget about any further “tapering” talk at this point. As one of the anchors on CNBC quipped yesterday, “why not just go ahead and cancel Christmas right now?” and for once, we would tend to agree with him. In our view, all these factors should add up to a fairly benign environment for fixed income through year-end and probably through the first quarter of 2014.
In spite of yet another week of significant outflows in mutual fund flows, we believe investors should start rediscovering the value in municipals, particularly if the Puerto Rico market stabilizes.
Obviously, we’re not the only ones to have reached this conclusion, as evidenced by yesterday’s meaningful Treasury rally which took the yields on the benchmark 10-year and 30- year bonds to 2.55% and 3.62%, respectively.
In spite of yet another week of significant outflows in mutual fund flows ($1.29 billion for the week ended October 16th), we believe investors should start rediscovering the value in municipals, particularly if the Puerto Rico market stabilizes (more on this later). Inter-market ratios are particularly attractive on the long end of the curve (around 111% in 30 years) and less so in the 10-year range, where they have dipped below 100%.
Puerto Rico Goes on the Offensive
It’s fair to say that no other major issuer has been subject to greater credit scrutiny than the Commonwealth of Puerto Rico and its instrumentalities over the last few months. On Tuesday, under tremendous pressure from the market, the Commonwealth of Puerto Rico (PR) finally broke new grounds in its disclosure efforts: it held an informational webcast that was open to all investors, not just a few privileged institutional bondholders. In fact, PR now intends to become the poster child of municipal disclosure, with monthly revenue updates and quarterly investor calls, a welcome change from its former stance. We do hope that the Commonwealth will also provide full disclosure on its private loans also.
Puerto Rico now intends to become the poster child of municipal disclosure, with monthly revenue updates and quarterly investor calls, a welcome change from its former stance.
A full analysis of PR’s recently released financial information would go beyond the scope of this column (for a copy of our upcoming update report on PR, please contact us directly at research@axiosadvisors.com). We can, however, offer a few preliminary observations regarding some key issues we heard on the investor call.
Obviously, with yield levels on PR paper reaching new highs going into the call, there was little room for mistakes. To the extent that the Padilla team came out with a comprehensive and informative presentation that did not reveal any new negative information, the investor call can be viewed as a success.
Not surprisingly, Commonwealth officials categorically confirmed that default or bankruptcy on its debt is not an option at this time. But then again, what else could they really say that wouldn’t turn into a self-fulfilling statement?
We were surprised that the financial team decided to address the “clawback” issue on COFINA debt head-on. One of the reasons for the recent underperformance of COFINA bonds is the persistent rumor that, in the event of a default or bankruptcy, sales tax revenues might be subject to a “clawback” by G.O. creditors. PR officials cited strong legal opinions from local as well as stateside counsel that revenues pledged to COFINA financings would not be subject to clawback. While such clarification is certainly helpful, we’re not sure market participants can fully rely on it, as we all realize that anything can happen in a default/bankruptcy scenario, particularly one that is adjudicated in local court.
As we’ve discussed before, everything still boils down to PR’s struggling economy. To address that concern, the Commonwealth also released a five-year economic development plan aimed at exploiting the island’s inherent strengths, including a well-educated bilingual work force, among other factors. While the plan, which was probably devised by the Boston Consulting Group, sounds impressive at face value, we remain skeptical about its successful execution, as it really doesn’t address a key issue: the very high cost of doing business on the island. Even the effort to lower energy costs through conversion to natural gas will take several years to implement. And, of course, the tax burden on corporations is still rising.
On the budget front, we’re encouraged that revenues are tracking fairly close to projections, with corporate tax increases basically making up for still declining personal income tax receipts. We were looking forward to hearing more about the Commonwealth’s stepped up revenue collection efforts but that topic, sadly, was not covered.
Most importantly, in our view, the GDB now claims it has access to enough “liquidity” (read: private financings from commercial banks) that it can stay away from the public market until at least June 2014. Quite understandably, the Bank is loath to pay the kind of long-term interest rates that the public market would require currently. At this writing, a Junior Subordinated COFINA issue as proposed would require yields in the high 8.00/low 9.00% to clear the market.
When asked by Thomson Reuters what the Commonwealth would target as an acceptable rate on its upcoming COFINA financing, Treasurer Acosta Febo replied: “less than 7.00%.” This, of course, translates to a rally of at least 150 basis points from current levels by next June. Quite an ambitious, if rather unrealistic, target, in our opinion. It would be interesting to see how long PR can adhere to the 7.00% line in the sand.
For now, based on the initial reaction from the market, the investor call appears to have accomplished its purpose in stopping the free fall in PR bonds. With some help from a firmer Treasury market, COFINA bonds have rallied by about 25 basis points, although there are unconfirmed rumors that Barclays has been the one supplying the bid.
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