If the first two trading days of 2014 are any indication, credit concerns will continue to weigh heavily on the tax-exempt market. Perhaps more importantly, the industry’s regulators are now also keenly aware of the changing credit landscape in munis.
Already, the new year is starting out with more headline risk for Puerto Rico: yesterday, a Wall Street Journal article highlighted the fact that the yield on the Commonwealth’s G.O. bonds ended 2013 at an all-time high. The island’s bonds maturing in 10 years reportedly hit a record yield of 9.87% last Friday.
Just about a year ago, in response to Puerto Rico’s gubernatorial election results, we published our comprehensive report on the Commonwealth’s bonds, titled: “Post-Election Puerto Rico: Systemic Risk or High Yield Opportunity?” As events unfolded throughout 2013, the answer to our question turned out to be: “both,” depending on who you ask.
During his first year in office, Governor-elect Padilla has surrounded himself with a competent financial team, particularly Treasurer Melba Acosta Febo, and they’ve done their best to manage a very difficult fiscal and economic situation …
During his first year in office, Governor-elect Padilla has surrounded himself with a competent financial team, particularly Treasurer Melba Acosta Febo, and they’ve done their best to manage a very difficult fiscal and economic situation in 2013, probably the worst in the Island’s history.
On the fiscal side, the Padilla team has taken all the tough fiscal medication required to reduce a structural deficit that has been building up over decades from previous administrations: they ended questionable budgeting practices, raised revenues where needed, pushed through landmark pension reform legislation and worked toward making PR agencies such as PRASA and PREPA more self-sufficient.
Although it took the better part of the year, the new Administration finally figured out in October that the market is looking for greater transparency and better disclosure. Since then, they’ve done a much better job of communicating with investors. (The clarification of the COFINA bonds’ status with regard to “clawback” issues is one example of improved disclosure, although, by talking up the COFINA security, the Commonwealth may have undermined the market’s perception of its basic G.O. credit in the process.)
Overall, the Padilla team has been successful in transmitting a positive “willingness to pay” message to the market. Unfortunately, the island’s “ability to pay” may well be beyond the Administration’s control, at least in the short-term: such ability to pay will ultimately be driven by the performance of the PR economy. Although some degree of stabilization can be seen over the past three months, the PR economy continued to contract last year and demographic trends have remained extremely unfavorable.
In some other respects, the Padilla team still doesn’t “get it:” they’re still relying on more debt, more taxes and convoluted cash flow maneuvers to get by. While revenue increases are unavoidable given the fiscal situation, they certainly won’t help the underlying economy recover from recession. The recent proposal to create a local version of COFINA is, at the end of the day, just another scheme to further leverage the same constrained economic resources. Similarly, the recent placement of $110 million in GDB notes with the State Insurance Fund Corporation is merely a reallocation of cash flows among public corporations with no net cash improvement, as far as we can tell. And, furthermore, the GDB was forced to pay the Insurance Fund a stunning interest rate of 8.00% for relatively short 3- to 5-year debt maturities.
The Commonwealth’s disclosure practices, although improved, still leave much to be desired: so far, it has resisted investor calls to provide full cash flow statements for the GDB, arguably the most opaque, and potentially weakest, component of their financial structure. Without this disclosure, it has been near-impossible for market participants to figure out the true liquidity position of the Commonwealth as a consolidated entity.
Although the availability of private short-term financings from banks as well as crossover investors did buy the Commonwealth some time in 2013, the rating agencies are now focused on long-term capital market access as a key credit factor. This has put pressure on PR to demonstrate market access as soon as possible, to ward off a potential downgrade to sub-investment grade status.
Just yesterday, GDB President Pagan told The Bond Buyer the Commonwealth intends to return to the market by the end of February. This announcement has stirred up much speculation. Does this mean the Bank expects to see much firmer economic indicators over the next two months? Or is the Padilla team resigned to taking its bitter pill right now, instead of running the risk of seeing things deteriorate further down the road? Perhaps it has received backstop funding commitments from a few hedge funds? Either way, it will be a high-stake gamble on the part of the Commonwealth.
Of course, one also needs to define what “market access” means to a quasi-sovereign entity like Puerto Rico. Is it access to capital at any cost, even at usurious rates? Or is it access to capital at an acceptable cost? By the first definition, the Commonwealth still has market access, even if it may end up paying over 8.50% for its best-secured COFINA debt. By the second definition, however, PR has already been shut out of the market, probably since last summer.
Not surprisingly, market access and rollover risk are also on the regulators’ radar screen this year. As we discussed in our last column, regulatory risk will be a major issue for the broker-dealer community in 2014, particularly those firms with a high yield retail focus. FINRA has already announced its intent to focus on “suitability” issues with regard to high yield or distressed bonds sold to individual investors. To quote from the Agency’s just-released annual report on its regulatory and examination priorities:
“In 2014, our examiners will focus on concentrations in longer duration instruments, including bond funds with longer average durations, and high yield securities recommended to retail investors, especially if those investors have near- term liquidity needs or have a conservative or defensive investment profile.”
In recognition of the shifting rate environment, FINRA will also zero in on debt rollover risk for many stressed or distressed municipal issuers:
“Well-known examples of municipalities in significant financial distress including Detroit, Puerto Rico and others highlight instances where investors may face real harm from both a credit and market risk perspective. While many municipal bonds remain strong investments, the additional funding costs associated with a potentially rising interest rate environment pose a broader risk to the market. When long-term interest rates increase, municipalities may be forced to roll over retiring debt at higher rates. These incremental factors could exacerbate financial distress in municipalities already straining under the burden of falling tax receipts. Most at risk would be those issuers with significant debt maturing in the near- to mid-term, unrated issuers, and those with less capital and liquidity to absorb the additional expense.”
In light of FINRA’s new priorities, it certainly would behoove broker-dealer firms, particularly those who underwrite high yield paper and cater to high net worth investors, to improve disclosure of key risk factors to their clients, such as duration risk and credit risk (For instance, access to independent, objective credit research could certainly go a long way toward educating the retail investor).
Not since the New York City debacle in 1975 have we seen this level of anxiety among all muni market participants about bond issuers’ market access and debt rollover risk. This is shaping up to be another challenging year indeed.
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