A new wave of social and political unrest, from Bangkok to Caracas, and then to Kiev, is providing the fixed-income markets with fresh support, keeping the benchmark 10-year Treasury yield inside the 2.70-2.75% band for now. How much of an impact the severe winter has had on economic activities is also a hotly debated topic as recent data continue to show slowing growth.

In the municipal market, the continuing absence of any real supply, with this week’s new issue calendar barely topping $2 billion, will ensure that activities will once again be light in this holiday-shortened week.

Traders were freed to focus on credit issues. Although yesterday’s investor call from the Commonwealth of Puerto Rico captured the market’s attention, another equally important development is unfolding in Detroit. Today marks the first day of hearings regarding the unsecured status of the city’s G.O. bonds. The outcome of this debate, whatever it may be, will surely go down as a watershed event for the tax-exempt market.

Puerto Rico’s webcast: Some quick takeaways

As you may know, the Puerto Rico Government Development Bank (GDB) hosted another investor webcast on Tuesday. Although the call itself was quite informative (you can find the presentation here), investors looking for more details will be well-served to check out the quarterly disclosure document that the Commonwealth also posted on EMMA yesterday.

While we’re still poring through the report and digesting the wealth of information provided, here’s our first take on what we heard on the call:

Overall, we thought the call was rather disappointing to the extent that a lot of details were disclosed but few of the critical credit issues were addressed. Perhaps we expected too much from something that was meant to be, first and foremost, a public relations effort. During the Q&A period, there didn’t seem to be any rhyme or reason as to whose question was chosen to be answered: some investors, particularly a couple of hedge funds, got through with multiple questions while hundreds of others went unanswered. Be that as it may, it was interesting to see names such as Arrowgrass Capital Partners and Amici Capital among the attendees. A quick check of their respective web sites revealed that Arrowgrass is a London-based, European-focused alternative asset manager, while Amici is apparently a long-short equity manager. Talk about newcomers to the municipal space!

To give credit where credit is due, the information disclosed on the call convinced us, once again, that the Padilla Administration is doing everything in its power to restore fiscal stability.

As expected, the Commonwealth revealed it will come to market in March with approximately $2.8 billion of tax-exempt G.O. bonds. This will be its first public sale since the PREPA deal in August of 2012, although it certainly has tapped into private funding sources repeatedly during the second half of last year. We suspect that, if decent demand does materialize for the new issue, the Commonwealth’s underwriters won’t have any qualms about pushing the issue size above the $3 billion mark.

The shocker, at least as far as we’re concerned, was the Commonwealth’s apparent capitulation to the hedge funds’ demand that it give up its sovereign immunity and allow itself to be sued in the Southern District of New York court, a venue considered more friendly to creditors. We did find out later, after the call, that there already was a precedent for this: the Commonwealth granted this right to RBC Capital when it privately placed $400 million of PR Highway short-term notes with the bank last year. Was this ever publicly disclosed to the market? We don’t think so. Just another example of the kind of selective disclosure practices the Commonwealth has been engaging in.

Of course, to us, the most glaring omission of all was the absence of any discussion on potential tax reform efforts, particularly the proposal to replace the SUT with a VAT about which we alerted our readers last week. (We did try to ask the question on the call but were roundly ignored).

The other interesting revelation, in our view, was the fact that sales and use tax (SUT) collections continue to disappoint, no great surprise given the recent string of dismal economic data. SUT collections during the first half of FY2014 showed a 6.3% year-over-year increase but were still 9.3% below original budget estimates. In light of this trend, the Commonwealth has formally revised its projected SUT collections downward by $251 million. Conversely, as if by magic, Treasurer Melba now expects the entire shortfall to be made up by higher-than-expected corporate tax collections. If this does in fact occur, the General Fund will be more dependent than ever on corporate taxes, to the tune of 26% of the entire budget.

To give credit where credit is due, the information disclosed on the call convinced us, once again, that the Padilla Administration is doing everything in its power to restore fiscal stability. The new target date for eliminating the structural General Fund deficit has been moved up to FY2015, the FY2013 CAFR is expected to be released on time this year, and new legislative efforts have been passed to wean all public instrumentalities from their historical dependence on the GDB and force them to become financially self-supporting.

Accomplishing that worthwhile goal may not be as easy as it sounds. Up until recently, most investors have placed PREPA in the upper tier of PR credits, as a quasi self-supporting entity. Moody’s, through its recent downgrade of PREPA, questioned that assumption by highlighting how much the Authority still depends on the GDB for liquidity. A recent proposal to restructure the Authority and turn it into a bona fide regulated utility makes sense in the long run but may raise a host of legal issues in the short run. (Ironically, even as the Commonwealth was conducting the investor call, Fitch Ratings came out and downgraded PREPA to BB-plus from BBB-minus and PRASA to BB-plus from BBB-minus.)

Before you get too carried away with PR’s newfound “market access,” bear in mind also the following: the new bond issue is likely to have the best security and the tightest legal protection that money can buy. In other words, once the deal comes, all the outstanding PR debt will become de facto subordinated, much to the dismay of current bondholders. Just make sure you factor that into your relative value decisions.

Going into yesterday’s call, there was a widespread expectation from many market participants that a relief rally in PR bonds may occur once the new issue is priced. While that may, in fact, turn out to be the case, we suspect any bounce will be short-lived unless the island’s fundamental economic data show signs of stabilization. As we’ve stated many times before, a successful placement of the new G.O. bond issue may buy the Commonwealth some breathing room for the next 18 months but it does very little to address the fundamental problem: how to align the Island’s debt burden with its shrinking economy. In fact, one could argue that adding more expensive debt with more onerous terms to the balance sheet is actually taking a step backward. Unfortunately, PR has put itself in the unenviable position of having to get past the short-term liquidity problems at any cost before it can address longer-term issues.

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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