With this week’s new issue calendar still struggling to top $2.5 billion and mutual fund flows turning positive again, the municipal market remains in a very comfortable technical position. Last year’s credit shocks from Detroit and Puerto Rico appear to wearing off and even a new tax reform proposal from House Ways and Means Committee Chairman Dave Camp has failed to cause much of a stir. As we’ve pointed out time and again, once you get beyond market anomalies such as Puerto Rico, the relative value of the tax-exempt sector is indeed quite compelling.
High yield buyers will probably flock to the latest $177 million New Jersey Economic Development Authority Special Revenue Bonds for Continental Airlines. Although the severe winter has resulted in a record number of flight cancellations and a probable short-term hit on earnings, the airline industry is basically in the best fundamental shape it’s been in decades. If nothing else, this B2/B-rated high yield name should garner strong demand due to the virtual absence of yield supply away from Puerto Rico. No wonder the initial yield talk is a rather lofty 5.75% in 2030, or about +260/AAA.
Puerto Rico Rebound
As expected, PR G.O.s are staging a significant relief rally in the wake of the 2/18 investor webcast. According to Municipal Market Data, PR GO spreads vs AAA in 5 and 10 years have tightened by 115 BP in the last week alone (through 2/21).The 30-year range has also rallied, but more modestly, with spreads tightening by only 25 BP. Absolute yields on 10-year PR G.O.s currently stand at just over 9.00%.
Not surprisingly, the worst-performing security structure at the start of the year, the PR G.O.s, have rebounded the most. Year-to-date through 2/25, the S&P Municipal Bond Puerto Rico G.O. Index is up a whopping 11.14%, compared to just +2.76% for the S&P National AMT-Free Municipal Bond Index, with the bulk of the performance occurring in February. Even after this recent rally, the PR Index is still down 14.06% over the last 12 months, compared to a loss of only 1.37% for the National AMT-Free Index.
Investor concerns about PR’s “market access” appear to be receding, at least for the time being. In fact, with details about the proposed security structure still being finalized, our sources are telling us there should be strong demand for the new G.O. issue. Assuming the $50 million minimum order holds, will this result in a two-tier PR market, with the most senior and best secured debt trading only among large institutional holders? Only time will tell.
Regarding the Commonwealth’s potential waiver of its sovereign immunity for the new issue, legal expert Jim Spiotto, co-publisher and co-owner of Muninetguide.com, offered this insight: “Generally sovereigns do not want to waive their right to a home field advantage, namely to have claims against them tried in the sovereign’s own courts. In time of financial challenge where sovereigns need funds to bridge the financial crisis and to finance a recovery plan, creditors will require “good as gold” protection for rescue financing. That will include allowing enforcement of rescue financing claims to be heard in a neutral or creditor friendly jurisdiction. Also rescue financing will require statutory backed dedication of the source of repayment and the assurance such dedicated funds are sufficient and can only be used to pay the rescue financing. Finally any sovereign pursuing rescue financing needs to assure its current creditors that their rights and sources of repayment are not beings sacrificed for the rescue financing. This assurance is required to not further lose market credibility and to demonstrate how this rescue financing is part of a recovery plan that is permanent fix and not another Band Aid.”
Based on Jim’s comments, it is important for Puerto Rico to explain how its upcoming bond deal is connected to a “permanent fix.” Is the Commonwealth about to squander its sovereign immunity on a mere “Band-Aid” solution? Something to think about.
Detroit: GM Redux?
As you may have heard, Detroit’s Emergency Manager Kevyn Orr and his team filed the City’s Plan of Debt Adjustment last week. To the dismay of the muni bond community, the proposed treatment of G.O. ULT bondholders deemed “unsecured” did not change materially from the initial proposal.
As summarized by The Bond Buyer, the Plan “offers unsecured non-retiree creditors, including most unlimited-tax and limited-tax GO holders, a roughly 20% recovery on claims (…) The recovery rate could go up if the City brings in more revenue during the restructuring process.
Based on the value of pensioners’ original claims at the time of Detroit’s bankruptcy filing, the recovery rates for the police and fire retirement fund is estimated at 20.8-29.8%, and for general retirement system 27.5-33.3% (…) Public safety retirees would preserve more than 90% of their “current” annuity and general retirees more than 70% if they agree to a deal with the city and state and give up the value of their annual cost-of-living increases. The recovery rates are three to five percentage points higher with the $820 million DIA plan.”
By now, one can’t help but be disturbed by the growing similarities between the Detroit bankruptcy case and the infamous bailout of the auto industry a few years ago. The populist approach of pitting Main Street against Wall Street, of favoring union interests over bondholders, is very much in evidence here, made even easier in Detroit’s case by the fact that most of the unsecured debt is insured. Taking into account the recent side deals involving contributions of $380 million from private foundations as well as another potential $350 million from the State, union pensioners stand to come out well ahead of bondholders.
With the bond insurers leading the charge, we’re encouraged that the buy side is finally marshalling its legal resources to defend one of the foundations of public finance, the G.O. pledge
Here’s what James Sherk and Todd Zywicki of the admittedly conservative Heritage Foundation wrote about the auto bailout in a June 13, 2012 Wall Street Journal op-ed piece:
“GM and Chrysler owed billions of dollars to the union’s Voluntary Employee Beneficiary Association (VEBA) when they went bankrupt. The union and the auto makers created VEBA in 2007 to assume responsibility for the UAW’s generous retiree health benefits. The benefits allowed UAW members to retire in their mid-50s with minimal out-of-pocket health-care expenses for the rest of their lives. GM owed $20.6 billion and Chrysler owed $8 billion to VEBA as unsecured claims.
A bedrock principle of bankruptcy law is that creditors with similar claims priority receive equal treatment (our emphasis). In the auto bankruptcies, however, the administration gave the unsecured claims of VEBA much higher priority than those of other unsecured creditors, such as suppliers and unsecured bondholders.
At the time of bankruptcy, GM owed these unsecured creditors $29.9 billion, for which they received 10% of the stock of “new” GM, which went public in November 2010, and warrants to purchase 15% more at preferred prices. Yet VEBA got 17.5% of new GM and $9 billion in preferred stock and debt obligations.
The administration also insulated the UAW from most of the sacrifices that unions usually make in bankruptcy-at taxpayer expense. Section 1113 of the Bankruptcy Code enables reorganizing companies to improve their post-bankruptcy competitiveness by renegotiating union contracts to competitive rates (…) The administration decided not to do this at GM. The UAW did accept sharp pay cuts for new hires. But they only made modest concessions for their existing members, like eliminating the much-maligned Jobs Bank that paid workers even when they were laid off.”
Sounds familiar? Perhaps it’s no coincidence that a VEBA is also being proposed to take over health care liabilities for Detroit retirees.
After getting effectively steamrolled by the City’s legal team early in the bankruptcy process, Detroit’s bondholders and bond insurers are finally fighting back. Any hope that the initial G.O. haircut proposal was just an “opening salvo” has been dashed by the latest Plan of Adjustment. With the bond insurers leading the charge, we’re encouraged that the buy side is finally marshalling its legal resources to defend one of the foundations of public finance, the G.O. pledge. It may just come down to what that “pledge” means: is it just a promise or is it an actual lien on revenues? That will be up to Judge Rhodes to ultimately decide.
Regardless of the outcome of the Detroit case, the market may never price G.O. risk the same way again. In the long run, G.O. credit spreads should factor in whether any particular state has a statutory lien backing its G.O. pledge and whether or not it allows Chapter 9 filings. Within the G.O. category itself, spreads should widen sharply as one moves down the quality scale, since concerns about security only come into play for lower-rated issues, say below “A.”
And investors should be doubly wary of states – like Michigan – with a history of favoring labor over capital.
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