Global financial markets continue to be buffeted by the events in the Ukraine, with volatility rising in both directions. After selling off on Monday, equities staged a strong rebound on Tuesday as Vladimir Putin, under pressure from the West, appeared to limit his territorial ambitions to Crimea for the time being.
The bond market, of course, has gone in the opposite direction, giving up all its flight-to-quality gains from the last few days. After all is said and done, the benchmark 10-year Treasuries ended up back at around 2.70% once again.
… the new [Puerto Rico] financing only buys the Commonwealth a temporary liquidity reprieve and does absolutely nothing to resolve longer-term credit concerns.
Barring another geo-political flare-up overseas, the next market-moving event for bonds should be the monthly employment report due out on Friday. Early indications are that employment may once again come in on the light side of expectations. Today’s ADP report already fell shy of consensus at 133,000. That said, we may due for a surprise on the upside. The latest Beige Book report from the Federal Reserve did confirm improving economic activities in most parts of the country, even if dampened significantly by the harsh winter weather.
The supply outlook in the tax-exempt sector brightened considerably this week as the new issue calendar returned to a more normal level of about $5 billion. The recent scarcity of deals drove muni ratios to their lowest levels in months, substantially diminishing the relative attractiveness of the asset class. The 30 year ratio for instance now stands at 103%, down from 109% back in mid-November.
Next week, the muni market’s attention will be fixated on the new Puerto Rico GO issue, slated to price on Tuesday, March 11. At this point, assuming favorable market technicals continue to hold, it appears this record-breaking high yield tax-exempt deal with be met with decent demand and the market-clearing yield could end up well shy of the double-digit mark, probably in the low 9.00% handle. We’re hearing unconfirmed rumors that the issue is already heavily oversubscribed.
As we pointed out in our latest PR update (you can obtain a free copy by writing to us at research@axiosadvisors.com), the new financing only buys the Commonwealth a temporary liquidity reprieve and does absolutely nothing to resolve longer-term credit concerns. The latter can only be alleviated by a stabilization of the underlying economy. Significant risk factors remain, and one could even argue that the new issue will worsen PR’s debt picture going forward. For instance, the Commonwealth may not have any GO debt capacity left after this deal, so its financial flexibility going forward will be significantly constrained. The new issue will also create a two-tier market for Puerto Rico debt, with crossover investors sitting in the catbird seat at the top of the capital structure.
Furthermore, all the disclosure required by the new issue, particularly a just-released detailed analysis of the GDB’s liquidity position, has all but confirmed the market’s worst fears about how tenuous the Bank’s solvency status has been up to the this point.
For now, however, the Padilla team can probably bank on one thing: its creditors’ desire to play ball and not to rock the boat at this critical juncture. In the absence of comparable yield alternatives anywhere in the global markets, greed should prevail and the successful placement of this issue should stabilize the market for PR bonds for the next few months. It will also remove a major source of uncertainty weighing on the tax-exempt market overall. Although municipals have already performed wonderfully on a year- to-date basis, even a decrease in the fear factor related to PR could unlock further outperformance versus Treasuries, particular if Treasury yields rise. Mutual funds have reportedly been maintaining above normal cash cushions in fear of further investor redemptions. They may now feel encouraged to put that cash to work.
Of course, as soon as we get some relief on PR, other credit issues may raise their ugly heads. Chicago, for one, is back in the spotlight, having just been downgraded by Moody’s to Baa1 from A3 on concerns about its crushing unfunded pension liabilities. The rating agency even maintained a negative outlook on the city’s $8.3 billion in outstanding debt. It will be interesting to see how the market reacts to this unprecedented downgrade for a major metropolitan area, as the Windy City prepares to re-enter the market as early as next week with a $400 million issue. If you recall, credit spreads on Chicago GOs had been tightening in sympathy with the State’s pension reform efforts. This latest round of downgrades serves as a reminder that the City has its own set of fiscal problems, many of which will defy easy solutions.
Another potential source of headline risk, this one more limited to the high yield sector, is the potential bankruptcy filing of Energy Futures Holdings Corp., the former TXU Energy.
As you may recall, Goldman Sachs launched this record-setting leveraged buyout of the company in 2007, just as natural gas prices were peaking. Needless to say, their timing could not have been worse as natural gas prices have steadily declined ever since as a result of the “fracking” boom, among other factors.
While this event has been widely anticipated by corporate investors for more than a year, some muni fund shareholders may be surprised to find out they have exposure to this name. There are about $1.3 billion outstanding in pollution control bonds guaranteed by TXU and most of them are held by some of the same funds that are already over-exposed to PR. The muni debt ranks fairly low within Energy Futures’ capital structure, even below the corporate senior unsecured debt, so recovery prospects may be grim. Over the last few weeks, retail pieces of the debt have reportedly been trading as low as 1-2 cents on the dollar! If it’s any consolation, bondholders are in good company: according to Bloomberg, even Berkshire Hathaway has taken an $873 million hit on this investment.
Overall, market participants should enjoy a well-deserved break from the relentless barrage of bad news on PR, even if such a break may well prove short-lived. In fact, any follow-through rally after the new deal is completed may be viewed as a selling opportunity, particularly if you are a retail investor looking for liquidity.
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