Market Outlook
Janet Yellen’s confirmation hearings went swimmingly yesterday, allowing 10-year Treasury yields to rally to around 2.70%. Municipals also rallied in tandem, with yields on the long end declining by three basis points.
Meanwhile, flows into tax-exempt bond funds continue to head in the wrong direction. Weekly reporting funds hemorrhaged another $903 million for the week of November 13th, according to Lipper. Long-term muni funds lost $608 million, up from $450 million reported the previous week, and high-yield muni funds saw outflows of $144 million. At this time of the year, we suspect fund redemptions must be driven to some extent by tax loss harvesting.
Without a fresh catalyst, trading volume in Puerto Rico (PR) paper appears to have waned in recent days. Late yesterday, Fitch Ratings placed PR GOs and related debt on Rating Watch Negative, while re-affirming the rating on Cofina. Since Fitch’s GO rating already stands at BBB-, this effectively puts PR on the edge of a downgrade to “junk”.
Given where PR paper is trading, we don’t view this as significant news and remain of the opinion that the rating agencies will give the Commonwealth the benefit of the doubt until at least the end of the first quarter of 2014. On the positive side, the Padilla Administration appears to be redoubling its efforts to reduce tax evasion and improve revenue collections, something we’ve been recommending for quite some time.
Seeking Salvation in the High Yield Muni Market
Last week, we wrote about a potential surge in high yield muni supply going into year end. One of the issues currently in the market does bring back memories of some infamous projects financed by non-rated bonds in the early days of the high yield market.
Cultural and other faith-based projects funded by unrated muni bonds have had a checkered history in [the municipal bond] market.
The City of Williamstown, Kentucky is offering a $62 million unrated taxable issue to build the Ark Encounter, a biblical theme park whose centerpiece will be a full-size replica of Noak’s Ark. The concept here is to eventually construct an entire amusement park with state-of-the art technology to re-create such iconic items as the Tower of Babel, the Ten Plagues of Egypt and, of course, the famous Ark, complete with a petting zoo of animals that may have made it aboard the famous vessel.
The borrowers will be related units of Answers in Genesis (AiG), a Christian ministry which intends to use the theme park as a means to advance “Young Earth Creationism” and a literal interpretation of the Book of Genesis. This will be a pure project financing, meaning the bonds will be secured only by gross project revenues and various reserves. There is a first mortgage pledge of all the facilities, however, given the nature of the project, finding an “alternative use” for the assets could be challenging (how would one foreclose on an Ark?).
Cultural and other faith-based projects funded by unrated muni bonds have had a checkered history in our market. Most have fallen under the category of misguided economic development efforts by local government officials, and default rates have been extremely high.
There is nothing wrong with faith-based projects, of course, as they may benefit from a fervent and loyal audience. However, such audience is also, by definition, limited, and projecting attendance is always a huge challenge. We actually think the idea of recreating the Ark is quite brilliant as the story of Noah has captured the imagination of children and adults alike for centuries. With all due respect to the Creationist faith, we just wish it could be presented in a more secular context to ensure the widest audience possible.
Among the myriad risk factors cited in the offering statement, one did catch our attention: “adverse weather conditions can seriously impact attendance at the Project.” One must assume that such adverse weather conditions would not include … flooding?
While the feasibility study cites other cultural attractions around the country as comparable attractions, the most relevant should be the Creation Museum, located just a few miles away in Petersburg, Kentucky and managed by the same group, AiG. In fact, the Museum is supposed to act as a feeder to the Ark Encounter since it attracts the same target audience. Its track record to date is not promising: since it opened its door in 2007, the Museum’s attendance numbers have steadily declined from 394,185 the first year to just 236,583 currently.
Jefferson County, Alabama is another muni issuer seeking salvation, or rather redemption, in the marketplace.
The Project’s sponsors will argue that the Ark’s attractions will be far more exciting than the Museum’s and that is probably true. However, a quick “back-of-the-envelope” calculation would tell you there isn’t much room for error. The project has to hit its attendance target of at least 1.2 million visitors out of the gate. The feasibility study projects annual operating expenses of about $28 million, and debt service for the first full year of operation of $5 million, for a total of $33 million. Using the forecasted average spending per person admission of $26, the project will need to attract at least 1.27 million visitors in its first year just to break even. (This is not meant to be a comprehensive credit analysis, of course. Please contact us at research@axiosadvisors.com if you’re interested in a full report).
Even true believers will be underwhelmed by the bonds’ proposed pricing: the $32.9 million term bonds due in 2028 are being offered at a taxable yield of 6.00%. Investors can get close to the same yield, but tax-exempt, from other investment grade bonds in today’s market.
Jefferson County, Alabama is another muni issuer seeking salvation, or rather redemption, in the marketplace. The County is looking to refund its water & sewer warrants as part of its plan to exit Chapter 9 proceedings. Eyebrows were raised among muni observers when Standard & Poor’s (S&P) assigned ratings of “BBB” to the senior tranche, and “BBB-” to the subordinated piece. Fitch disagreed and came out with below investment grade ratings of “BB+/BB.” Moody’s apparently was not invited to the party. Undeterred, the rating service went ahead and released an unsolicited rating opinion anyway, claiming the issue displays “below-investment grade” characteristics. Naturally, this put S&P in the rather uncomfortable position of being the only one out of three with an investment grade rating, a stance which it tried to defend on a webcast with investors yesterday.
On the webcast, S&P argued that its rating is intended to be “forward-looking.” In other words, the rating already assumes that everything will transpire as planned and that the county, under the watchful eyes of a bankruptcy judge, will stick to its side of the bargain for the next 40 years.
After taking a closer look at the deal, we must unfortunately side with Moody’s and Fitch. Let’s start with this philosophical point: should an issuer fresh out of bankruptcy, who just inflicted significant losses on its bondholders, be deemed investment grade without at least spending some time in junk rating purgatory? We, for one, don’t think so. It’s not a matter of being punitive. It is a matter of the recent past behavior being the best predictor of future behavior, until proven otherwise.
Consider also these additional factors:
First, the socio-economic backdrop for Jefferson County remains a mixed bag. On the one hand, Lumesis, a muni analytics firm, reports that their proprietary DIVER Geo score from for the County has improved to 5.5 from 3.5 a year ago (the DIVER Geo Score measures the relative economic health of the referenced geographic location, with 10 representing the best health. It’s not a credit score, however). On the other hand, economic data from Merritt Research still show the county underperforming both the Birmingham SMSA and the state in terms of growth in population, employment and per capita income over the past five years. Ever-increasing utility rates will further undermine the county’s economic competitiveness.
Secondly, the issue will be structured with a mix of current interest, capital appreciation and convertible interest bonds, resulting in very back-loaded debt service payments. When combined with significant future capital needs, this will put extreme pressure on the County’s ability to implement a steady schedule of annual rate increases over the next 40 years. The fact that the rate increases will be enforceable by a bankruptcy judge might provide some reassurance to investors; however, it’s not clear what jurisdictional issues may arise if future County commissioners balk at raising rates. Could a federal judge impose rate increases on an unwilling local entity? No one really knows. After all, the County has already shown a historical reluctance to raise sewer rates over the past five years for political reasons.
Given the projected shortfall in funds required for capital needs in 2024, we wouldn’t be surprised if the issue will need to be restructured again in about 10 years’ time.
Pricing-wise, we’re hearing talks of a 5.00% yield on the subordinate lien bonds in 2023, 6 1/4% in 2042 and 6 1/2% in 2053, rather ambitious levels for an issuer still in bankruptcy. According to the rumor mill, Citigroup as lead underwriter is leaving no stone unturned and has even approached overseas investors. Surprisingly, the issue is also being marketed to retail investors, who really shouldn’t be involved in this kind of credit, in our humble opinion. That said, in a worst case scenario, the hedge funds who were involved in the bankruptcy negotiations have reportedly agreed to backstop the issue.
Due to the built-in constraints on the range of interest rates the County can afford to pay as part of the bankruptcy plan, the issue may not come cheaply enough to entice even those high yield investors who are willing to take a gamble.
Overall, investors looking for tax-exempt income do have quite a bit to chew on this week and next. Do be careful not to buy bonds just on a wing and a prayer.
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.