In sharp contrast to prior months, this week’s FOMC meeting should be met with much less anxiety on the part of market participants. Both the equity and fixed-income markets have settled into a fairly comfortable groove, based on the belief that any Fed tapering effort will be delayed into the first quarter of next year. As a result, the yields on the benchmark 10-year and 30-year Treasuries have hovered within 2-3 basis points of the 2.50% and 3.60% levels, respectively.
As the Detroit bankruptcy hearings go into a fourth day, yields in the tax-exempt market continue to grind lower.
Of course, this newfound complacency could, in itself, be a sign of trouble. Yesterday, a Bloomberg article pointed out that recent moves in 10-year Treasuries are now positively correlated with moves in the S&P 500 Index, the first time this has happened since 2007. Prior to this month and over the past decade, the correlation was negative. This would suggest that both bond and stock markets are currently driven by Fed easing, and both may suffer when “tapering” concerns arise again.
As the Detroit bankruptcy hearings go into a fourth day, yields in the tax-exempt market continue to grind lower. Yesterday, the firmer tone in the secondary market allowed Municipal Market Data (MMD) to nudge their AAA scale down by 2-3 basis points in the belly of the curve and a more modest 1 basis point on the long end.
Then again, market participants are probably just exhausted from the relentless Puerto Rico-related pressure of the last few weeks. This well-deserved break may not last long. Next week’s Bloomberg State & Municipal Finance Conference in New York City will feature not one, but two panels on Puerto Rico, with Treasurer Melba Acosta Febo as one of the featured speakers. Even if it doesn’t produce any market-moving headlines, the Conference should produce some lively debates regarding the outlook for the troubled island economy. We’ll report back to you from there both as participant and observer.
New Issue Market
After last week’s big spike, the new issue calendar has come back down to around $4 billion this week. The negotiated slate will consist largely of liquid, highly rated issues: $600 million Special Tax Transportation bonds from the State of Connecticut (Aa3/AA/AA), $572 million Unemployment Compensation Fund Special Revenue Bonds from the State of Nevada (Aaa/AAA/AA+) and $618 million Revenue Bonds from the New York Metropolitan Transportation Authority (A2/A/A).
Puerto Rico’s Probability of Default
We were hoping we could avoid mentioning Puerto Rico (PR) at least this once. Well, no such luck. If you recall, we mentioned in Friday’s column that one of Standard & Poor’s own units, CMA, recently estimated PR’s probability of default at over 77%. This occurred the same week that S&P itself moved to reaffirm the Commonwealth’s “BBB-minus,” or “low investment grade” status.
Yesterday, one of Moody’s analytical units, Capital Markets Research (CMR), came up with a similar conclusion in a report titled “Puerto Rican Market Signals on Down Slope.”
According to the report, “market-based probabilities of default for Puerto Rico have deteriorated notably in recent months. The Commonwealth’s five-year cumulative CDS-implied EDFTM (Expected Default Frequency) credit measure, for example, rose from 10.42% in early September to 15.65 today (…). Puerto Rico’s five-year EDF measure currently maps to Caa2 on the Moody’s Investors Service rating scale; its one-year EDF measure, at 3.05%, to Caa3. Both of these metrics exceed those of all US states and all sovereign entities in our data set except Argentina.“
Interestingly, Jerry Tempelman and Yukyung Choi, the report’s authors, were not at all impressed by the rally in PR paper since the investor webcast, calling it a selling opportunity: “Given the lack of favorable fundamental prospects, we would take advantage of the recent price increase and reduce credit exposure to the Commonwealth by selling its longer-dated General Obligation issues.“
Again, as was the case with S&P, we have another instance of the left hand not knowing what the right hand does. We wonder how the Moody’s rating committee responsible for keeping Puerto Rico’s G.O. rating at investment grade level would reconcile its view with the CMR unit’s findings? Considering where PR paper is currently trading, even after the recent bounce, the market appears to be leaning toward the “Caa2” rating implied by CMR, rather than Moody’s official “Baa3” rating.
The Puerto Rico rating conundrum illustrates the difficulty of estimating default probabilities for municipal issuers.
Unfortunately, the rating agencies are currently stuck in a rather uncomfortable position. A downgrade to below-investment grade would become a self-fulfilling prophecy, triggering higher collateral posting requirements for the Commonwealth’s interest rate swaps and making it more difficult for commercial banks to continue to provide short-term liquidity. Presumably, the main reason institutions such as Barclays have been able to step up to the plate is that capital requirements under Basel III for “investment grade” general obligation debt have remained quite low. A downgrade to junk level would significantly affect the banks’ ability to bail out PR until it can regain normal capital market access.
The Puerto Rico rating conundrum illustrates the difficulty of estimating default probabilities for municipal issuers. Given the SEC’s new requirements under Dodd-Frank to reduce reliance on agency ratings, the race is on among muni research firms (including ourselves) to come up with viable alternative credit scoring systems. Most muni analysts favor a return to a more objective, data-based approach to predicting probabilities of default, within the obvious limitations of municipal disclosure practices.
That is easier said than done. Generally speaking, we’re skeptical of methodologies that attempt to estimate probabilities of default from either credit spreads or CDS quotes. For a relatively illiquid market such as munis, it’s very difficult to disaggregate the various components of bond spread – i.e., credit risk, liquidity risk, call risk, etc… In the corporate bond market, analysts prefer to use CDS spreads to derive probabilities of default because CDS are simpler in structure, e.g. no call provision. When it comes to municipals, however, things may not be quite as simple. In their recent paper on “Assessing Municipal Bond Default Probabilities,” Marc Joffe and Matthew Holian argue that “the applicability of CDS implied default probabilities to the municipal market is greatly limited (…) by the fact that CDS trades against a relatively small number of municipal issuers, and trading volume is low even for those issuers for which CDS are available.“
Of course, the entire assumption underlying either yield-based or CDS-based approaches is that the tax-exempt market is reasonably efficient at pricing credit risk. As we all know, efficiency has never been the hallmark of the municipal market, which is why tax-exempt bonds can be a credit trader’s paradise every so often.
The other fundamental problem with most credit scoring systems is that they’re almost always backward-looking, since they’re derived from historical data. A scoring system that uses both historical data and financial projections to come up with a probability of default would certainly move us closer to the Holy Grail of muni credit analysis.
Speaking of predictions, and with due deference to our large readership in St Louis (!), we just have to say: Go Red Sox!
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