Market Outlook
With the new issue calendar continuing its recent seesaw pattern, muni market participants are left to ponder two significant events this week: the FOMC meeting and the reportedly “balanced” budget announcement from the Commonwealth of Puerto Rico. The quickening pace of the Detroit bankruptcy negotiations has, to some extent, restored muni investors’ confidence in the credit outlook, even though this quarter’s default statistics are poised to rise as a result of a non-muni credit event, the Energy Future Holdings bankruptcy filing.
First, the macro picture: GDP growth was reported at an anemic 0.1% rate for the first quarter, compared to the 2.6 % growth rate in Q4, although economists still attribute much of the recent weakness to a harsh winter as well as to poor demand from overseas. Add to the mix the ongoing Ukraine situation, a stock market in corrective mode and you will have the recipe for a fairly benign rate environment, at least for the next few days. On the flip side, this morning’s ADP employment report came in on the strong side at 220,000, leading to some optimism for the April payrolls number due out on Friday. Of course, there’s always the potential for the markets to be roiled by a more hawkish-than-expected pronouncement from the FOMC.
Muni investors, for their part, should be content to sit on their impressive gains from the last four months and perhaps begin to lay off risk. On the one hand, one cannot deny the tax-exempt sector’s rock-solid technical underpinnings. On the other, it’s harder now to make a relative value case for munis, except on the very long end of the curve.
As bankruptcy proceedings go, Detroit’s Chapter 9 case could be breaking a speed record. Much of this may be attributable to Emergency Manager Kevyn Orr’s desire to wrap things up before his engagement expires. Once the deal with the insurers of the UT G.O. bonds was reached, many of the remaining key players have fallen in line in fairly quick order, including the police and fire pension funds and a committee of retirees negotiating OPEB liabilities. Trying to build on this momentum, Judge Rhodes has ordered the LT G.O. bondholders and Syncora, as insurer of the swaps and certain of the Pension Obligation Bonds, into mediation later this week.
Disappointingly, the only piece of the Detroit puzzle that has not made much progress is the plan to recast the City’s Water & Sewerage system into a regional utility.
On the one hand, one cannot deny the tax-exempt sector’s rock-solid technical underpinnings. On the other, it’s harder now to make a relative value case for munis, except on the very long end of the curve.
As we mentioned earlier, Texas-based utility Energy Future Holdings (EFH), the former TXU Corp., finally filed for bankruptcy last night, ending months of market speculation. Just like another previous large corporate bankruptcy, American Airlines back in November 2011, this latest LBO disaster may add as much as $1.2 billion of TXU-backed industrial revenue bonds to the muni default tally for this year, although a recent Bloomberg article could only identify about $400 million held by mutual funds and banks.
High yield muni participants may look back fondly upon the TXU credit, for many years one of their favorite trading opportunities. This once-staid investor-owned utility became a high yield name back in early 2002, a victim of energy market deregulation. At the time, an ill-fated expansion into the United Kingdom resulted in a massive write-off, triggering, as we recall, a 10 point sell-off in the tax-exempt pollution control bonds in a single day. Once TXU became part of a record-breaking $46 billion LBO led by Goldman Sachs, its fate was effectively sealed. Because that entire transaction was effectively a leveraged bet on natural gas prices, TXU-backed bonds became a play on gas prices and, for years, traded accordingly. We all know how that story ended.
New Issue Market
The new issue calendar declined again this week, barely topping $4 billion. On the competitive side, the State of Pennsylvania took full advantage of scarce supply conditions and, in spite of its ongoing fiscal challenges, sold over $800 million of G.O. bonds at extremely tight spreads.
Headlining the negotiated side is a $442 million Revenue Bond issue from William Beaumont Hospital, headquartered in Royal Oaks, Michigan. In the aftermath of the failed merger with Henry Ford Hospital, just about a year ago, investors would be well-advised to carefully consider William Beaumont’s ability, as a stand-alone system, to adapt to the new health care environment under the Affordable Care Act.
Puerto Rico’s New “Balanced” Budget
As expected, PR Governor Padilla last night announced a “balanced” budget for fiscal 2015, the first in 20 years, featuring about $1.4 billion in public spending cuts, equal to roughly 14% of the FY 2014 budget. According to Reuters, “the governor said he would cut government spending by an average 8 percent and added he would not make cuts to the Police Department or the University of Puerto Rico.” Other cost savings will come from consolidating the operations of some 25 government entities, apparently without loss of service quality or a need for further layoffs.
While we would reserve our final judgment on the budget until we see the actual details, it’s fair to say the announcement was already expected by the market and reflected in bond prices (the PR G.O. 8.00% of ’35 have rallied back closer to the original issue price). Also widely known is the fact that it is not quite a structurally balanced budget since the Commonwealth is still relying on about $270 million of capitalized interest from the last G.O. deal to pay current debt service. Be that as it may, one has to give the Padilla Administration full credit for coming through on its promises, something that cannot be said about past administrations. A $270 million “real” deficit is still infinitely better than the billion-plus number that we were estimating a year ago. What remains to be seen, however, is the ultimate impact of such a contractionary budget on the PR economy.
Away from the balanced budget talk, the Governor’s speech did little to dispel investor concerns about the potential restructuring of the public benefit corporations (PBCs). One may wonder if the Commonwealth is not trying to bolster its G.O. credit at the expense of the PBCs. After all, the plan is to wean the PBCs from the GDB for liquidity support and force the agencies to be self-supporting, which is easier said than done: PREPA, for instance, needs further capital market access to complete its ambitious capital improvement program. We doubt it can accomplish that in its current financial state without ongoing help from the central government.
Meanwhile, the economic indicators for the Island have actually shown some degree of stabilization over the past three months. Although the Puerto Rican economy is still contracting, it is doing so at a decelerating rate. Caribbean Business aptly summarized the latest economic statistics as follows:
“The EAI for March fell by 0.8 percent compared to the same month in 2013, posting a 16th straight monthly drop on a year-over-year basis. Last month’s decline, which followed a 2.5 percent drop in February, was the shallowest since February 2013 (…) The EAI has now risen for three straight months on a month-over-month basis (…) Importantly, the decline in March was due to the thinning of government payrolls. During this month, total private employment increased by 0.8 percent (5,300 jobs) on a year-over-year basis, while total public employment decreased by 3.8 percent (9,500 jobs) when compared to March 2013.”
Most economists would view the transition from government employment to private sector employment as a positive trend. As we’ve said many times before, the key to Puerto Rico’s economic survival is the reduction in the size of the public sector and the creation of a viable private employment base capable of absorbing its working age labor force (Importing new, wealthy residents from Greenwich, Connecticut is probably not a viable, long-term solution).
By coming through on its promise to deliver a “balanced” budget, free of new deficit financing, the Commonwealth has taken a critical step forward. Let’s hope its efforts to stabilize the economy will also start bearing fruit soon.
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