The bond market’s enthusiastic response to the unexpectedly weak December employment report is starting to wane as more recent economic releases continue to point to strong growth in the fourth quarter of 2013. As a case in point, December retail sales were reported up 0.2% (up 0.7% without auto sales), all but ensuring that Q4 GDP will be in the 2-3% range.
After hitting a low of 2.83%, the 10-year Treasury yield has now retraced much of its gains and currently stands at 2.87%.
Building on the momentum from last week, the tax-exempt market continued to rally yesterday, with generic yield levels declining by 14-19 basis points since last Monday. Today’s backup in Treasuries did take a bit of the wind out of the market’s sails but the underlying technical tone continues to look firm for the time being.
Activity levels should start to normalize this week, with new issue volume estimated at just under $5 billion, almost double last week’s paltry slate. Negotiated deals will dominate the calendar, led by $775 million from the New York City Transitional Finance Authority (Aa1/AAA/AAA). The second largest deal, $468 million in State of Minnesota’s General Fund Appropriation Bonds (as distinct from General Obligation bonds) for the new Vikings stadium, was postponed due to a last minute legal challenge. Another high quality issuer, the Jacksonville Electric Authority, is also bringing a mix of senior and subordinated debt totaling $250 million.
One issue did catch our attention on the high yield side: a $297 million taxable issue from the Industrial Development Authority of La Paz County, Arizona on behalf of LCS Corrections Services, rated “BBB/Stable” by S&P.
With many jail issues running afoul of the IRS’ so-called “private use” rules (e.g., Burnet County, Texas), the County was probably wise to sidestep any potential tax issues by going the taxable route.
Any student of the high yield muni market will tell you that jail deals have one of the highest historical default rates among all sectors, so it would behoove investors to really do their homework here. The contracts with Federal and state authorities (in this case, the U.S. Marshall Service) are usually short-term in nature and do not match the longer maturity of the bonds. As we’ve seen in California, among other places, the political environment can drastically affect the growth and composition of the inmate population.
This issue will go to refinance a group of six well-established jail facilities, three in Texas and three in Louisiana, with a combined capacity of 5,511 inmates, an average operating history of 13.5 years and an experienced operator, LCS Corrections Service. Based on a cursory review, we note that the project only requires a 66% occupancy rate to break even, even though the current occupancy rate is hovering right around 88%. Highlights of the bond security package include a gross revenue pledge and a fully funded debt service reserve fund (DSRF), with an additional DSRF accruing at 20% of maximum annual debt service per year. Raymond James, the underwriter, also seems to take disclosure very seriously and has built in some fairly stringent ongoing reporting requirements.
The current price talk on the 2034 term bonds is a 7.00% coupon to yield 7.50%, or just about +400 versus Treasuries. Although any long-term credit upside will probably be capped at “BBB”, we believe the deal is already priced at below investment grade levels. We further note the initial dollar price of only 94.839, giving the issue the potential to run up to par, a “make-whole” call and a relatively short 15-year average life.
On the subject of Detroit, we’ve tried to spare you a blow-by-blow account of the bankruptcy proceedings by focusing only on the most significant rulings. Along those lines, this week did bring a remarkable development: federal mediators were able to cobble together a pledge of as much as $330 million from a coalition of national and regional non-profit foundations, including the Ford Foundation. This unprecedented effort was intended to shield the Detroit Institute of Arts’ (DIA) world class art collection from creditors as well as make a contribution toward the city’s unfunded pension liabilities. It also hinges on further contributions of up to $500 million from the State and other DIA donors, another tall order.
No serious damage has been reported, fortunately, and investors can now go back to worrying about the next seismic shift in [Puerto Rico’s] fiscal and economic fortunes.
As laudable as it is, this effort to raise private funds to pay public obligations is likely to raise as many issues as it solves. The most obvious question is whether, under federal bankruptcy laws, the funds can be earmarked for just one class of creditors (pensioners in this case) or they have to be distributed to all creditors, including the City’s bondholders. It will be fascinating to see how Judge Rhodes will tackle this issue.
Regardless of how this latest twist in the Detroit saga will pan out, we find it quite encouraging to see the private sector begin to take responsibility for the future of this iconic American city.
Puerto Rico Update
As things currently stand, the future of Puerto Rico is one of those topics that can be discussed endlessly without ever reaching a definite answer. Depending on who you talk to and which angle you want to take, one can make an equally convincing case for either a full fiscal recovery or an eventual debt restructuring. In that vein, the Global Interdependence Center will be sponsoring yet another Puerto Rico conference tomorrow in New York City, featuring such market pundits as David Kotok from Cumberland Advisors and our good friend Natalie Cohen from Wells Fargo. Interestingly, no representative from the Commonwealth will be scheduled to speak. Either the Commonwealth was not invited or its officials are too busy working on the upcoming COFINA bond issue, we just can’t tell.
On a more disquieting note, the law firm of Jones Day, known for its restructuring expertise, is reportedly meeting with a few institutional muni investors this week to pitch PR restructuring scenarios. The meeting is not open to the public.
Last but not least, it’s only fitting that, given the tremors Puerto Rico has caused in our market over the last 18 months, the Island was hit by an actual 6.40 magnitude earthquake off is coastline last Sunday. No serious damage has been reported, fortunately, and investors can now go back to worrying about the next seismic shift in the Island’s fiscal and economic fortunes.
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