Market Outlook
A range-bound Treasury market has helped municipals maintain a steady, positive tone over the past few weeks. However, the recent stretch of outperformance has also eroded the relative value of the tax-exempt sector, leaving it vulnerable to a significant correction. Muni ratios are now at the bottom of their six-month range, only 86.5% in 10 years and 100.6% in 30 years.
This week will bring temporary relief from the supply drought. The new issue calendar is expected to surge to about $7.5 billion, headlined on the negotiated side by a $1.2 billion mix of tax-exempts and taxables from the New Jersey Economic Development Authority (A1/A/A+) and $700 million in Unemployment Compensation Revenue Bonds from the Texas Public Finance Authority (Aaa/AAA/AAA). The competitive calendar will include a $750 million G.O. issue from the once again-Golden State, which expects to see bids at a spread inside 50 basis points, a far cry from the 125 basis points exacted by the market during the recession.
But the week’s most interesting deal should be the $750 million G.O. offering from the State of Illinois, already the third time the State has accessed the market this year. In many ways, the Prairie State’s timing is impeccable. First, one couldn’t ask for better technicals than now, both from a supply and spread standpoint (spreads on Illinois G.O.s have tightened to less than 90 basis points off AAA). Secondly, the State can get ahead of all the uncertainty regarding confirmation of its pension reform plan, the extension of the income surtax and, of course, the gubernatorial race.
On the flip side, buyers looking to participate in the Illinois deal may want to consider if they’re adequately compensated for some potential credit volatility later this year.
Puerto Rico Update
Whoever has been advising the Commonwealth of Puerto Rico on its disclosure practices continues to do an abysmal job. Just today, in a stunning revelation, Treasurer Acosta admitted that the release of the GDB’s Fiscal Year 2013 Financial Statements ahead of the last G.O. issue would have “adversely affected” the market’s perception of that deal, by showing how tenuous the Bank’s liquidity position was and will continue to be. As you know, those famous financial statements were quietly posted to the GDB’s web site last week, more than a month after the G.O.s were priced. Perhaps most shocking is the fact that the Commonwealth would even admit to any of this! Investors in the G.O. issue may have good reasons to believe they were sandbagged.
Although there are signs that the Puerto Rican economy has stabilized, or at least stopped free-falling, the Credit Default Swaps (CDS) market is not giving them much credence.
Much has been made recently about all the restructuring experts who have been hired by the Commonwealth, among them New York-based Cleary Gottlieb. Lee Buchheit, one of Cleary’s principals, co-authored an interesting paper last October, titled: “Revisiting Sovereign Bankruptcy,” which contained the following quote on sovereign credit defaults:
“There is evidence that policymakers are often reluctant to restructure their debts and sub-optimally postpone unavoidable defaults (e.g., Borensztein and Panizza 2009; Levy Yeyati and Panizza 2010; IMF 2013). Delayed defaults can lead to the destruction of value because a prolonged pre-default crisis may reduce a country’s capacity and willing willingness to pay. Its capacity to pay is reduced because procrastination prolongs the climate of uncertainty, high interest rates and restrictive fiscal policies that are ineffective in avoiding default but amplify output contractions. Delayed defaults reduce its willingness to pay because electors that have suffered long periods of economic austerity are less likely to support a creditor-friendly debt restructuring (our emphasis).” Now, doesn’t this sound familiar to you?
Although there are signs that the Puerto Rican economy has stabilized, or at least stopped free-falling, the Credit Default Swaps (CDS) market is not giving them much credence. As we’ve discussed in past articles, Moody’s Analytics, a separate unit from Moody’s rating team, extracts a one-year “Expected Default Frequency” (EDF) for all the sovereign credits it follows from CDS spreads. In its latest report, dated April 21, 2014, the Moody’s Analytics team found that “the US commonwealth’s EDF measure indicates the second highest probability of default, after Argentina, of all the 84 sovereign entities in our data set (…) Puerto Rico’s one-year sovereign EDF measure has risen by 17% since April 8 to its current 2.7% level as of April 18.”
Lest we are blamed for being too negative, there is some economic hope for the Island on the horizon. As is usually the case with anything related to PR, it revolves around tax policy. Given its current heavy reliance on corporate taxes, the Commonwealth is trying to transform itself into a tax haven for the ultra-wealthy, particularly for hedge fund managers.
Back in 2012, under the former Fortuno Administration, Puerto Rico passed what are known as Act 22 and Act 20, or the Individual Investors Act and Export Services Act. They completely exempt new residents of the Island from Puerto Rican taxation on their capital gain, dividend and interest income. The Export Services Act levies a top 4% tax rate on earnings from businesses that perform services, like professional consulting, asset management, research and development, computer programming, and so forth, in Puerto Rico for clients outside of Puerto Rico. What’s more, these tax breaks will be protected from any legislative change until 2035 or so.
This could be a great solution to PR’s economic problems, almost elegant in its simplicity. Now that its capacity to finance through the traditional muni market is more limited, the Commonwealth would be smart to cater to the needs of the same constituency that will provide them with capital market access in the future. If all the hedge funds that are currently taking a bath on their PR G.O.s would just move their operations to the island, not only would they be able to take advantage of the new tax breaks, they might also enhance the value of their PR holdings in the process. So, what’s not to like?
Of course, such a blatant effort to erode the income tax base of the Federal government is bound to invite some kind of backlash from Congress. This is one loophole that begs to be closed, perhaps as part of the next federal tax reform proposal. And hedge funds are not known to employ very many people, so the impact on job creation may end up being quite modest (To qualify for Act 20, a service firm is only required to employ a minimum of three workers).
Are State and Local Pension Cost Reduction Efforts Stalling?
The dramatic underperformance of the new PR G.O. issue over the past two weeks has been blamed on, among other things, the PR Supreme Court declaring the Commonwealth’s pension reform legislation unconstitutional on April 11th. For those of you who have been keeping score, it seems that state and local government efforts to drastically restructure their pension liabilities have been met with only limited success so far. In spite of being the headline public finance issue in 2013, public pension reform seems to have run into a wall of late.
The most obvious setback has occurred in Rhode Island. In the Ocean State, what started out in 2011 as one of the most sweeping pension reform plans in the country has been successfully contested in court by the unions. A compromise solution reached in February, which would have preserved the bulk of the potential cost savings, also fell apart last week, leaving the whole mess to be decided by the RI Superior Court in September.
In Detroit, the most recent settlements call for city retirees to get 100 cents on the dollar in exchange for some minor COLA adjustments while UT G.O. bondholders end up with just a 74% recovery rate. Through the bankruptcy process, the retirement systems were also able to draw out additional support from private philanthropic organizations and from the State itself, potentially to the tune of $850 million. Clearly, the market’s expectations that Chapter 9 could become an effective means to restructure pension obligations have not been realized.
The City of San Bernardino, California, which has shown extreme courage in going after Calpers, is reportedly nearing an agreement with the behemoth State retirement system. Knowing what’s at stake for Calpers from a precedent-setting standpoint, we have a feeling the upcoming settlement will preserve the senior claim status of pension payments relative to bonded debt.
Even Illinois’ breakthrough pension reform, passed last December, still has to withstand a legal challenge by the unions before the State Supreme Court. The City of Chicago, facing a potentially crippling rise in pension contributions in 2016, has only been able to negotiate a settlement with its municipal and laborers unions but not with the more powerful Police and Fire organizations.
As bondholders and retirees fight for relative positioning within a local government’s capital structure, it would appear that the unions are currently getting the upper hand.
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