Market Outlook

Call it the “Sneaky Muni Rally.” If last year saw a perfect storm of negative technical and fundamental factors, the situation seems to have reversed in the new year, at least thus far. Since the holidays, building on the firmer tone in Treasuries and the return of positive fund flows (for the first time since May 2013), the tax-exempt market has quietly rallied and even outperformed its taxable counterparts. The Bond Buyer reported that, for the week ending last Friday, its Municipal Bond Index and 20-Bond GO Index dropped by 12 and 13 basis points, respectively. For the first time in quite a while, muni players can actually enjoy a normal January reinvestment period.

Given this week’s light economic data calendar, there shouldn’t be much to force 10-year Treasuries out of their recent 2.80-2.90% yield range. If nothing else, a lackluster corporate earnings season, combined with the political turmoil in Thailand, should keep a slight bullish bias to the interest rate outlook.

Unfortunately, the flip side of the current rally is that munis no longer look as compelling on a relative value basis, particularly on the short end of the curve. Muni ratios are now sitting at the bottom of their recent 12-month range: the 5-year and 10-year ratios are now at 70% and 92%, respectively. Only the 30-year ratio continues to exceed 100%, 104% to be exact. It’s fair to say the short-to-intermediate end of the muni curve is now in overvalued territory.

Retail flows can, of course, keep this rally going for a tad longer, but the downside risk is now higher than back in November, when we made the relative value argument for munis.

Needless to say, the [Tri-State] region’s transportation grid is about to be sorely tested by the hordes of football fans descending on the Superbowl, particularly if Mother Nature throws a wintry wrench into the proceedings.

As investor confidence about the economic outlook gradually improves, we would expect the high yield tax-exempt sector to pick up steam. High yield munis still compare very favorably to high yield corporates, and spreads have actually widened out since the fall. Barclays’ Ratio of Municipal High-Yield Index to its Corporate High Yield Index reached a stunning 120% at year end, an 18-year record high. Furthermore, Barclays’ BAA Muni Index ended 2013 at a spread of 313 basis points versus the AAA Muni Index, the widest it’s been since early 2011. The upshot? Low investment grade names currently offer the best relative values.

New Issue Market

With the Superbowl contenders now finalized and heading to MetLife stadium on February 2nd, and the Bridgegate scandal still dominating the national headlines, it’s only fitting that transportation financings in the Tri-State area should also dominate this week’s new issue calendar. Of the roughly $5 billion on this week’ calendar, $1 billion will be from a taxable issue by the Port Authority of New York and New Jersey and another $650 million from the New York State Thruway Authority. On the competitive side, the State of Washington will be floating $721 million of combined tax-exempt and taxable motor vehicle fuel tax GO bonds.

Scandal or not, we would expect the Port Authority bonds to garner a strong reception from muni investors. Proceeds from this week’s issue will reportedly go to fund redevelopment of the World Trade Center site.

Predictably, there are renewed calls to break up the Authority in the aftermath of Bridgegate, but for now, we would view those proposals as mere political posturing. A recent article by Crain’s New York detailed the difficulties of making structural changes to the Authority: investors have always taken great comfort in its diversified revenue base. In other words, when it comes to the Authority’s massive operations, the whole has always exceeded the sum of its parts.

The Crain’s article goes on to say: “The Port Authority’s diverse revenue streams also mean it can borrow more cheaply than the airports or bridges could on their own. That’s an important consideration because the agency has $20 billion in debt obligations and is expected to borrow another $8 billion over the next four years to pay for such projects as completing the World Trade Center, building a new central terminal at LaGuardia Airport and raising the Bayonne Bridge so larger ships going to and coming from the Panama Canal can dock here.”

Needless to say, the region’s transportation grid is about to be sorely tested by the hordes of football fans descending on the Superbowl, particularly if Mother Nature throws a wintry wrench into the proceedings.

Along the same line, perhaps we should expect the high yield Meadowlands/American Dream issue, a.k.a. Xanadu, which we discussed in an earlier article, to re-appear on the calendar soon?

Detroit Update

The latest surprise coming out of the Detroit bankruptcy proceedings was Judge Rhodes’ refusal to approve the City’s settlement with the swaps providers. The Judge ruled last week that the settlement proposal by the City was too high and that the City never really pursued any legal avenue to invalidate the swap counter-parties’ claims. For instance, Detroit could claim the pension obligation bonds that were hedged by the swaps were invalidly issued and, as a result, it shouldn’t have to honor its obligations for either the bonds or the swaps.

Whichever way this may work out, pension obligation bonds as a security class continue to be an open target for creditors.

On the surface, Judge Rhodes’s decision sounds reasonable until one realizes that the casino revenues the City is so anxious to have released were pledged as a result of a previous settlement. Back in 2009, Detroit and the bond insurers were facing another round of downgrades which would have resulted in a termination event for the swaps, at great potential cost to the City. As part of a forbearance agreement with the swap providers, the city agreed to pledge its casino tax revenues to the swaps, with a lockbox mechanism set up in the event of further credit deterioration. Given that history, it would be extremely disingenuous for Detroit to now try to invalidate the terms of the previous settlement, in our view. Who would ever trust the city to negotiate in good faith again?

Whichever way this may work out, pension obligation bonds as a security class continue to be an open target for creditors. Investors and bond insurers alike should start treating this type of security with extreme caution.

Puerto Rico Update

Even in the dead of winter, hope springs eternal in the Puerto Rico (PR) market. Puerto Rico bonds held up well last week, shrugging off largely unfounded rumors of an impending debt restructuring. Year-to-date, S&P reports that its Municipal Bond Puerto Rico Index is up 2.89%, versus +1.72% for its National AMT-Free Muni Index. Of course, if you recall, PR bonds also outperformed in the first quarter of 2013, only to resume their decline over the balance of the year.

Although last week’s PR Conference sponsored by the Global Interdependence Center didn’t break any new ground, many participants were surprised by Standard & Poor’s rather bold statement that any potential “G.O. clawback was not applicable to PREPA and PRASA.” While we ourselves may lean toward that view with regard to PREPA, we would be much more skeptical about PRASA being “clawback-safe,” given PRASA’s long history of receiving Commonwealth subsidies, and in spite of recent efforts to make the Agency more self-sufficient.

Speaking of PREPA, Governor Padilla has proposed several changes to the Authority’s operations and oversight. The Governor is looking to establish a new regulatory commission to review and approve electrical rates, similar to state utility commissions on the US mainland. Other items on his reform agenda include more public participation in the rate-setting process, promotion of energy efficiency and conservation practices and subsidies for electric cars, etc…

While efforts to reduce electricity costs and stimulate demand are always laudable, PREPA bondholders should also consider the Authority’s potential loss of rate-setting flexibility, particularly in the context of a more politicized rate-setting process.

In truth, there’s so much PR (as in “public relations”) noise coming out of PR now, we would advise investors to keep focusing on the factors that will truly impact the Island’s creditworthiness. Otherwise, all this may become the equivalent of hearing Peyton Manning yell out “Omaha.” In other words, mostly distracting, and not very informative.

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.

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