“A long, long time ago
I can still remember how “prop trading” used to make me smile
And I knew if I had my chance
That I could make those clients pay
And maybe I’d be happy for a while”
With all due apologies to Don McLean, today may soon be known as “the day the prop trading died,” at least as far as our largest banks are concerned. After almost three years of debate, no fewer than five separate U.S. financial regulatory agencies have unanimously approved the so-called Volcker Rule, a key component of the Dodd-Frank financial system reform effort. The new Rule aims to discourage the largest banks from engaging in trading activities for their own accounts, the kind of risk-taking activities that regulators think could bring down our entire financial system.
Although the devil is always in the final details, the most significant change from the early draft of the Rule has been the allowance for “market-making activities,” as opposed to proprietary trading, however defined. Much tougher risk management requirements are also in store, thanks to J P Morgan and its “London Whale” disaster. In the past, so-called “portfolio hedging” was sometimes used as a cover for large, directional profit trades. In this new environment, hedging activities at the portfolio level are no longer allowed and any hedging instrument now has to be clearly associated with the underlying security it’s designed to hedge.
This week’s impressive calendar won’t make up for the fact that the overall muni market has been shrinking all year.
Although “state and local government obligations” are presumably exempted from the proprietary trading restrictions, the early definition for such obligations did not include many of the conduit agencies that customarily issue bonds in our market. Taken at face value, this restrictive definition would’ve resulted in a multi-tiered market. According to the Bond Buyer, the final rule does include a broadened exemption for states, localities, subdivisions, and agencies of muni issuers.
It will take a few weeks, if not months, for market participants to figure out precisely what impact the Volcker Rule will have on the municipal market. It’s probably fair to say that liquidity is likely to suffer going forward, particular with regard to high yield and distressed issues which have historically ended up in the banks’ proprietary accounts due to their longer workout horizon.
In the meantime, the fixed-income markets continue to take the latest batch of strong economic data in strides, even as they had to digest another Treasury auction this week. At this writing, the benchmark 10-year Treasury yield is holding steady around the 2.80% mark, give or take a couple of basis points.
Puerto Rico Update
According to Barclays’ latest index returns, after a sharp rebound in October, Puerto Rico bonds slipped again in November with a -1.30% return, versus a -0.21% return for the Barclays Municipal Bond Index.
This trend may continue into year end. Puerto Rico’s Government Development Bank (GDB) finally released its Economic Activity Index for September and October, and, as expected, the news continues to be grim. The index fell 5.2 percent in September from the same month of 2012, and by 5.4 percent in October, for an 11th consecutive year-over-year drop. The Index is now back to a level not seen since 1994. For those of us looking for silver linings, the indicator did show improvement on a month-over-month basis, rising by 1.1 percent in September and by 0.6 percent in October, the first consecutive monthly gains since 2012.
New Issue Calendar
Many muni issuers and their bankers consider this week their last chance to get into the market before the holidays and, more importantly, before the December FOMC meeting. And they’re taking advantage of this short-term window: this week’s new issue calendar is expected to reach $11 billion, almost double the amount sold last week.
The New York Utility Debt Securitization Authority gets our vote for “most interesting deal of the week.”
Investors will be able to choose from quite an assortment of negotiated mega-deals: a $2 billion refunding issue from California’s Foothill/Eastern Transportation Corridor Agency; $2.1 billion ($1.6 billion tax-exempt and $485 million taxable debt) from the New York Utility Debt Securitization Authority; and $1.6 billion of New York State Thruway junior debt.
Among these, the least controversial should be the New York Thruways, rated A3 by Moody’s and A- by S&P and with a final maturity of only 2019.
More eyebrows will be raised for the Foothill/Eastern issue, which is basically an attempt to stave off default for this long-beleaguered toll road in Orange County, California. The refunding, split-rated Ba1 by Moody’s and BBB- by both S&P and Fitch, stretches out the Agency’s debt service schedule to match revised traffic growth projections. However, the structure does rely heavily on capital appreciation bonds. Should future development along the toll road’s corridor fail to materialize, it will only be a matter of time before another restructuring will be required.
The New York Utility Debt Securitization Authority gets our vote for “most interesting deal of the week.” For those of you who have not been following the story over the last two years, the Long Island Power Authority (LIPA) has come under severe criticism from State officials and consumers alike for its poor management and service record. This new financing came as a result of New York State’s decision to strip LIPA of most of its electric utility operations and outsource them to a unit of New Jersey-based Public Service Electric and Gas Company (PSEG). As part of this transition, the State was convinced it could reduce its debt costs by levying a new restructuring charge on LIPA customers, use this new revenue source as security for a new highly-rated bond issue and use the bond proceeds to retire up to $2.5 billion of outstanding LIPA bonds (LIPA’s current senior debt ratings are Baa1/BBB-/BBB-). The Debt Securitization Authority was created solely as a conduit for this transaction.
Based on our preliminary reading of the Preliminary Official Statement, it appears the underwriters have tried to anticipate most of the potential legal issues that may arise from this kind of debt structure, including future legislators’ propensity to renege on their predecessors’ commitment. However, interested investors would be well advised to read through all the offering documents for this rather complex deal, particularly the “Risk Factors” section.
LIPA’s ability to continue to issue tax-exempt debt would be a critical factor, now that most of its assets have been transferred to a private utility. The Authority is presumably still waiting for a final opinion from the IRS on this subject.
As a securitized cash flow deal, the transaction is expected to obtain conditional AAA ratings from all three rating services. Now, when was the last time the rating agencies gave their AAA ratings to a securitization deal? Think Mortgage-Backed Securities. It makes you wonder, doesn’t it?
At the end of the day, in order to pay AAA prices for this issue, one needs to be convinced that the financing structure is fully insulated from the performance of the underlying utility. Would this hold true when the next Super Storm Sandy hits? Only time will tell.
This week’s impressive calendar won’t make up for the fact that the overall muni market has been shrinking all year. According to the Bond Buyer, “long-term issuance has fallen 15% this year through November, to $301 billion (…) Calendars averaged about $6.27 billion each week through November, down from $7.35 billion in the same period in 2012.” Over the next few weeks, we’ll explore what this implies for our market, going into 2014.
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.