The “Ides of March” are again upon us. In the fixed-income markets, this usually means a backup in yields as the supportive effect of year-end cash re-investment flows starts to recede. This year, however, the US economic outlook has been obfuscated by the severe winter weather around the country, limiting any potential yield correction. Friday’s February payrolls report did clear up some of the confusion by showing employment continuing to grow at a steady, if lackluster, pace.
For now, global geo-political issues (e.g. events in the Ukraine) should help keep the benchmark 10-year Treasury yield in a 2.60-2.80% trading range.
New Issue Market
The municipal market is also going through its own, but much more modest, version of a March correction. Over the first two months of the year, tax-exempt yields had staged a powerful rally on virtually non-existent supply: from year end through February 25, the 10-year and 30-year MMD AAA yields dropped by 26 and 40 basis points, respectively. Since then, yield levels have risen slightly in response to the prospect of resurgent supply.
The favorable technicals were certainly too good to last: this week’s calendar has surged to over $11 billion, although skewed to some extent by Puerto Rico’s record $3.5 billion deal and the State of California’s $1.8 billion G.O. issue. The divergent fortunes of these two sovereign (or quasi-sovereign) credits is startling: California, once the market’s whipping boy for poor fiscal management, has become the golden child again, and it is quite happy to be overshadowed by Puerto Rico in the media headlines.
Away from the two large G.O. issues, this week’s new issue slate certainly has something for everybody. New York investors can partake in a $830 million State Personal Income Tax Revenue issue from the New York Dormitory Authority. Looking for revenue bonds? Houston, Texas is also coming with a couple of First Lien Revenue Refunding issues, $685 million tax-exempt and $606 million taxable.
Overall, with a revived calendar promoting price discovery and a successful Puerto Rico deal in the record books, the tax-exempt market should be in great shape to absorb whatever bond underwriters may throw at it over the next few weeks.
Puerto Rico’s Mega-Deal: A Post-Mortem
As we like to say in the investment business, there often comes a point where fear in the marketplace turns into greed. The Commonwealth of Puerto Rico found that inflection point this week with its epic high yield G.O. issue.
If the price is attractive enough, risk capital from somewhere around the world will show up to fund.
When all is said and done, Barclays as the lead underwriter was able to take advantage of a five times-oversubscribed order book and upsize the deal by $500 million to $3.5 billion. The final pricing of an 8.00% coupon to yield 8.727% to the 2035 maturity, with an average life of only about 16 years and call protection for only 6 years, was also a far cry from the double-digit predictions made by market observers (we at Axios Advisors included) barely a month ago.
To give credit where credit is due, one has to admit Barclays did a rather masterful job of pricing this mammoth issue. The original issue dollar price of 93 may have been designed to give short-term traders and market makers a chance to re-trade the bonds a few times in the secondary market and make a decent 1-2 point profit on each turn. Ultimately, assuming a relatively stable market environment, the bonds should end up at a price of around 97 to retail broker-dealers, who in turn can apply their usual 1-3 point markup and put bonds away to individual investors at or near 100 (par). In the end, everybody should be happy (!), including the ultimate buy-and-hold holders who will pay par for the privilege of clipping an 8.00% coupon. As some of our market friends pointed out on Twitter, this PR G.O. issue had all the hallmarks of a hot technology IPO.
At the risk of stating the obvious, once the imminent threat of restructuring receded, the 8.00%+ yield proved too irresistible, even to those who couldn’t take advantage of the triple tax exemption. After all, even bonds from troubled Ukraine are reportedly yielding in the low 9.00%. Even within the high-yield tax-exempt market, only startup CCRC financings would fetch that lofty a yield.
Does this mean the Commonwealth left some money on the table by not pushing for an even lower yield? Perhaps, but it needed to promote a “good feeling” among all market participants about this financing. After all, the island may have to return to the market soon with another financing, either for COFINA or for COFIM, the new local version of COFINA. Just to make sure the buyers show up next time, what’s another 7 points (or $245 million) between friends? Call it a down payment toward future market good will. Are we being too cynical? Guilty as charged.
Should we have been surprised by the apparent success of the deal? Perhaps not, once you realize that the whole PR situation has become something of a self-fulfilling prophecy. Once short-term liquidity and “market access” became the key market concerns, the PR crisis became very much a binary situation: either the Commonwealth had “market access,” in which case the liquidity problems should be resolvable, or it did not have “market access,” which could only mean imminent default and/or restructuring.
As we’ve discussed before in this column, we don’t think “market access” was ever the real issue, particularly these days when global capital markets are awash with liquidity. If the price is attractive enough, risk capital from somewhere around the world will show up to fund. So the real issue has always been: “market access, but at what cost”? Once the Padilla Administration, with their back against the wall, conceded that cost was no longer an issue, “market access” immediately became a moot point. In fact, to further demonstrate that cost is really no longer the issue, the Commonwealth even flirted with waiving its sovereign immunity to accommodate the hedge funds. Thankfully, it settled with a more limited concession regarding jurisdiction in the event of default.
Note that we keep emphasizing the “short-term” effect. The hedge funds that did provide support for this record high yield issue are certainly not in for the long haul, driven as they usually are by quarter-by-quarter performance. The pressure remains on the Commonwealth’s leadership to turn the PR economy around over the next 18 months. Unless economic indicators start to stabilize soon, the crossover investors’ patience could wear thin very quickly.
Having spread the PR problem to a new group of investors, muni market participants can breathe a well-deserved sigh of relief and re-focus on other pressing issues.
One of those issues may well be the outlook for another major metropolitan area, Chicago. The Windy City is also in the market this week with a couple of G.O. issues, $430 million tax-exempt and $400 million taxable, fresh off a downgrade by Moody’s to Baa1. The preliminary yield talk on the taxable bonds is around +265 over Treasuries, a rather attractive level in our view, given that Chicago paper was trading at +200 or tighter not too long ago. Although we, like the rating agencies, are also concerned about the lack of legislative response to the looming pension funding crisis, we do think Chicago’s problems are ultimately resolvable, given the City’s solid socio-economic foundation.
As our senior analyst Carol Karsten put it, “there are two types of willingness that investors seek: one is willingness to pay (something Orange County, CA did not have when it opted to default on TRANs), the other is willingness to fix issues. Illinois suffers from a perceived unwillingness to resolve its issues.” We think the same can be said of Chicago, and the city is paying a heavy price for its unwillingness to address the pension issue. Needless to say, investors should view this as an opportunity.
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