The bond market was looking for bad news this week and found it in the minutes of the FOMC, released on Wednesday. Apparently, tapering has remained on the table, which really shouldn’t surprise anyone. However, the Committee did leave the door open for taking action as early as December, and that didn’t sit well with traders.
In response, the yield on the benchmark 10-year Treasury notes initially shot up 10 basis points to as high as 2.80% but has now settled down to around 2.75%.
Much is being made in the press about the steepening of the Treasury curve, especially between the 2- year and the 10-year range. The 2 to 10 year spread started the year at 159 basis points, got as tight as 143 in early May (before the bond market selloff) and now stands at 250, the widest in more than two years. With the front end of the curve locked down by expectations of no rate increase from the Fed in the foreseeable future (even after tapering begins), further steepening would seem logical if the economy remains on its steady, if unspectacular, growth path.
The muni market started the week with a positive tone but saw its momentum dashed by the Treasury selloff on Wednesday. Tax-exempts still managed to outperform their taxable counterparts and, as a result, muni ratios fell to 95% in the 10-year range and 106% in the 30-year range, not quite as attractive as earlier in the month.
Yesterday, muni investors thought they had finally gotten some good news about mutual fund flows, but that turned out to be a mistake. On Thursday afternoon, Lipper first reported inflows but then reversed themselves. And so we ended up with outflows again for the 26th consecutive week. For the week of November 20, $770 million left weekly reporting funds, compared to outflows of $903 million for the week of November 13. High-yield muni bond funds also lost assets.
After a tumultuous last six months, the market for Puerto Rico bonds appears to have settled down for the time being.
High yield spreads also widened, which traders blamed on the very cheap pricing of a hospital deal, a $161 million issue from the Southwestern Illinois Development Authority for the Memorial Group. Only S&P rated the bonds, at “BB+,” and the terms in 2048 were priced at an eye-popping 7 ¼% coupon to yield 7 5/8%. From what we can gather, the attractive pricing was required by the buyers to compensate them for credit-specific risk factors. We really wouldn’t draw any conclusion about investors’ appetite for high yield paper in general. After all, other “high yield” new issues such as Guam didn’t have any problem getting done at much lower yields.
The refunding issue for bankrupt Jefferson County, Alabama is now on the books. Two years after the County filed the second largest municipal bankruptcy in history, U.S. Bankruptcy Judge Thomas Bennett confirmed the plan of adjustment on Thursday, paving the way for the County to emerge from Chapter 9. The final recovery rates for the County’s creditors will be about 22 cents on the dollar for J P Morgan (which stands to reap more fees for its role in providing the reserve fund LOC for the new deal) and between 65 to 80 cents for holders of the sewer warrants. Such recovery rates are significantly lower than historical norms for an essential service issuer, and they may well become the “new normal” in munis going forward.
So far, the secondary market action on the new refunding warrants has been a bit sloppy. The Bond Buyer reports that as much as $200 million of the subordinate lien bonds did not find a permanent home. As a result, the subordinate lien current interest warrants 6 ½% in ’53 (472682rm7), have traded down by as much as two points over the last two days. All the other maturities have fared better, holding right around the original issue price.
In our view, the Assured Guaranty senior lien bonds still look attractive if they could be purchased at the original spread.
Puerto Rico Update
After a tumultuous last six months, the market for Puerto Rico bonds appears to have settled down for the time being. Even Fitch’s recent negative credit watch announcement hasn’t caused much of a stir, beyond the regular ebb-and-flow of the high yield sector. The next catalyst for renewed trading activity could be the release of the September Economic Activity Index from the GDB, already long overdue. Everyone expects an ugly number, so any positive surprise (even a stabilization of recent negative trends) could really firm up the bid side on PR bonds.
Speaking of economic indicators, we pointed out in earlier reports that the Island has been steadily losing its younger, productive workforce, presumably to the U.S. mainland, a trend that does not bode well for its long-term outlook. This is vividly illustrated by the following chart, courtesy of Richard Ciccarone at McDonnell Investment Management, using data from Merritt Research:
One of the reasons Puerto Ricans are leaving the island in droves is, of course, the lack of jobs. The latest employment report from the BLS bears this out: the October jobless rate ticked up to 14.7%, from 14.5 % in September. The 12 month rate of change in non-farm payrolls came in at -5.0% in October, slightly better than the -5.4% reported for September. The Government sector showed the second largest annual decline in employment (down 8%) after Mining, Logging & Construction (down 17.3%). This goes to show how the administration’s fiscal retrenchment, while absolutely necessary, can turn into a fiscal drag on the economy.
We’d like to take this opportunity to commemorate the 50th anniversary of President Kennedy’s assassination. When I was in Dallas last month attending an analyst conference, I had the chance to revisit the JFK memorial site and the whole experience just felt as chilling and shocking as the day I heard the news as a young boy. Here’s hoping our nation never has to experience anything as traumatic again.
On a happier note, our best wishes to my longtime friend, Richard Ciccarone, who is retiring at year end from his post as head of research at McDonnell Investments after an illustrious 35-year municipal bond career. In his case, though, “retirement” is probably a misnomer since Rich intends to devote his “spare” time and energy to his other ventures as head of Merritt Research and co-publisher of MuniNetGuide. I, for one, look forward to working closely with Rich as we intend to blaze the muni information and research trail for the next decade.
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