After her “failure to communicate” last week, Fed Chairwoman Yellen went out of her way on Monday to clarify that no rate increase is in the cards, given the current dismal state of the job market. Her remarks did lead to a partial reversal of the curve-flattening trades which were initiated following last week’s FOMC meeting.
The employment outlook will be back on traders’ radar screen this week, with the March payrolls report due on Friday. This morning’s ADP report was solidly on consensus at +191,000, perhaps even a tad on the strong side given the significant 48,000 upward revision to last month’s number.
As if that wasn’t enough to set the fixed-income market on its heels, along comes Federal Reserve Bank of Atlanta President and CEO Dennis Lockhart with predictions of rate tightening by the second half of 2015. As a result, the benchmark 10-year Treasury yield is once again re-testing the 2.80% level.
The tax-exempt market, meanwhile, is basking in the aura of an excellent first quarter, its best in five years. Investors have apparently woken up to the compelling relative value offered by municipals after a dismal 2013, with the help of a range-bound Treasury market and a continuing dearth of supply. Needless to say, the first quarter’s performance will be tough to match going forward, as munis will continue to take their cue from Treasuries.
As we’ve often noted before in this column, assuming no inflation spike, the current economic environment should be particularly supportive for credit-sensitive instruments. The high yield muni market’s recent performance bears this out: The Barclays Non-Investment Grade Index gained an impressive 5.91% in the first quarter, almost twice the 3.32% rise for the high grade Barclays Municipal Bond Index, riding on a strong rebound by Puerto Rico and tobacco bonds.
And the game may not be over: again according to Barclays, the spread between its High Yield Municipal Index and its Investment Grade Municipal Index remained at its widest since 2009 at 410 Basis points, compared to an average spread of only 282 Bps since October 1995. This suggests there may be more room for spreads to tighten further.
… assuming no inflation spike, the current economic environment should be particularly supportive for credit-sensitive instruments.
As of March 31, the yield on the Muni High Yield Index stood at 130% of its corporate counterpart, after hitting an 18-year high of 133% a few weeks ago. How compelling is this ratio? Since January 1996, it has averaged only 75%. While high yield corporates have already come a long way in this cycle, high yield tax-exempt paper appears to have quite a bit of room to outperform going forward.
New Issue Market
Education is clearly the theme for this week’s new issue calendar. On the negotiated side, the University of California System (Aa2/AA-) will be coming with a $968 million combined tax-exempt and taxable issue, to be followed by the University of Texas with a $270 million offering. At the local level, we will see new bond offerings from the San Diego Unified School District ($261 million, Aa3/AA-) and the San Jose-Evergreen Community College District ($251 million, Aa1/AA). The competitive calendar will be dominated by a $120 million deal from the Lancaster County School District No.1, NE.
The week’s most notable deal, however, won’t have anything to do with education: through the Karegnondi Water Authority, the city of Flint and a group of local governments in Southeastern Michigan will be floating a $220 million issue to finance their break away from the Detroit Water and Sewerage Department and build their own 63-mile pipeline to Lake Huron. This is another setback for Detroit Emergency Manager (EM) Kevyn Orr in his efforts to restructure the Detroit Water & Sewer into a regional entity and make the participating suburbs pay up for Detroit’s services.
Mr. Orr’s proposal has already ruined what most investors took as the best-secured debt in the Motor City’s capital structure: the water and sewer bonds. Although Orr has never questioned the “secured” status of this revenue debt, his “debt exchange” offer is tantamount to a default, if not a monetary default then at least a technical one. The rating agencies have responded by downgrading the bonds deep into “junk” territory: on March 25, Standard & Poor’s Tuesday downgraded Detroit’s nearly $5.9 billion of water and sewer bonds to CCC, just one step above actual default.
Faced with the less-than-enthusiastic response from Detroit’s suburbs to his proposal, Mr. Orr has been considering yet another option: privatizing the system. We find it hard to believe any private company would want to take on this amount of debt without some sort of restructuring.
Still on the subject of Detroit, bankruptcy Judge Steve Rhodes finally approved the $120 million debtor-in-possession (DIP) loan from Barclays today. Proceeds from this financing will presumably go to various “quality-of-life” projects within the city. Interestingly, this latest version of the DIP will not cover a proposed $85 million settlement with the City’s swap providers. Judge Rhodes intends to take up that issue separately later this week.
[Detroit’s] latest Plan of Adjustment proposes an even deeper haircut on the debt deemed “unsecured…”
By now, it’s become quite clear to most market observers why the EM has gone out of his way to try to settle with the swap provider banks. According to The Bond Buyer, “if the court approves the swaps deal, it means Detroit will have the acceptance of at least one impaired creditor class of its bankruptcy debt plan. That’s enough to impose a cram-down on the rest of the city’s creditors”.
That tactic would be consistent with the City’s apparent desire to beat the unsecured creditors into submission. The City’s latest Plan of Adjustment proposes an even deeper haircut on the debt deemed “unsecured”: instead of 20 cents on the dollar, the unsecured G.O. bondholders and pensioners now stand to get only 15 cents! One of the reasons for the lower proposed settlement is the fact that that certain OPEB liabilities are now included in the unsecured creditor class, thus lowering everyone’s recovery.
The new Plan does include some additional recovery for the police and firefighter pension plans to induce them to play ball. As far as we can tell, no such inducement was offered to the bondholders.
Recognizing that Kevyn Orr and his team’s application of corporate bankruptcy concepts to the municipal arena may not make complete sense, Judge Rhodes has announced he will seek the advice of a panel of municipal experts, headed by Harvard economist Edward Glaeser. Who should be on that panel? To us, the choice is easy: MuniNetGuide’s own Richard Ciccarone and Jim Spiotto. They’re both concerned and engaged citizens as well as long-standing experts in our field.
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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