Market Outlook
The bond market is having the last laugh. All market participants went into this year bearish on bonds and, at least so far, have ended up with eggs on their face. The surprising drop in rates over the past few weeks has led many to wonder if the economy is about to take a turn for the worse yet again. Although corporate earnings were quite robust in the first quarter, many companies appear to be hedging their bets in their Q2 outlook.
We suspect there are more technical than fundamental reasons at work here. Against the backdrop of a lackluster job recovery, geo-political concerns, first about the Ukraine and now about Thailand, have led investors to take some risk off the table. Many probably went into the new year too short their duration benchmark and have had to adjust their portfolios accordingly. The rising need for investment income has certainly made it difficult to be under-invested in bonds for any length of time.
For their part, FOMC officials are sticking with their economic recovery scenario: according to the minutes released today, they spent the bulk of their last meeting debating how to “normalize” interest rate levels.
After a brief dip below 2.50%, the 10-year Treasury bonds are now back within the recent 2.50-2.70% trading range.
New Issue Market
As we head into another holiday-shortened week, the tax-exempt new issue calendar should total around $4 billion, headlined by a $894 million offering from the Missouri Highways & Transportation Commission and a $650 million G.O Refunding issue from the State of Connecticut (which, interestingly enough, came on a negotiated rather than competitive basis, a reflection of the State’s less-than-sterling fiscal status).
Once we get beyond the Memorial Day holiday, the visible supply does appear to be building up in June as issuers try to tap into the potential June-July reinvestment demand.
Direct Bank Lending to Muni Issuers: A Step Backward in Disclosure
On occasion, we’ve been admittedly tough on our colleagues at the rating agencies. However, we must applaud their latest attempt at forcing issuers to disclose the terms of their bank loans or face the prospect of losing their ratings. Standard & Poor’s appears to have taken the lead role in this process, as shown by this excerpt from a letter that the company recently sent out to its clients:
“(…) We are aware that recently, direct bank loan financing has been utilized more regularly as a component of municipal entities’ capital strategies. Very frequently, these loans are on parity with outstanding, publicly-held debt obligations. Unfortunately, disclosure of these agreements has been erratic at best, which does not serve to enhance transparency in the municipal market.
In order to both maintain our rating(s) on your current obligations, and possibly assign future rating(s) on additional debt, we require that we are notified and supplied with all relevant documentation related to any private debt, including bank loan financing, that you enter into, regardless of whether the private debt is being rated by Standard & Poor’s. Notification and provision of documentation should occur, at the latest, promptly following closing of such private debt. This enables us to assess the credit impact of such financing and to incorporate such assessments into our analysis of your capital platform. If you enter into such an agreement, and we are not informed in a timely manner and supplied with the documentation, we may, suspend or withdraw your rating in accordance with our published procedures(…)”
Increasing bank lending activities have been partially blamed for the recent drop in muni issuance.
Standard & Poor’s concerns are absolutely well-founded. As documented by Cate Long and other market analysts, the rise of direct bank lending to municipal issuers threatens to undermine recent efforts to improve disclosure practices in the muni market. Incredible as it may sound, issuers are currently not required to report either the size or the terms of their bank loans. You won’t find any of those items on EMMA, despite a recent effort by SIFMA to encourage voluntary disclosure of such loans through a White Paper. Last year, the lack of transparency regarding a few critical private financings probably contributed to the market’s paranoia about Puerto Rico’s true fiscal condition.
And this problem can only get worse. Increasing bank lending activities have been partially blamed for the recent drop in muni issuance. Estimates of the banks’ presence in the tax-exempt market to date range from $60 to as much as $200 billion, and still rising.
Unfortunately, while S&P’s and SIFMA’s efforts are a commendable first step, issuers probably won’t pay much attention until the market starts penalizing them for failing to disclose their private transactions.
A Chinese Municipal Bond Market
While we’re on the subject of disclosure, the word “transparency” usually doesn’t come to mind when talking about China. Yet, the Chinese government is apparently toying with the idea of establishing a local municipal bond sector, in response to rising concerns about unchecked growth in local debt leading to a potential credit crisis.
There is currently a thriving market in so-called “fake” local municipal bonds. According to an article posted on FT.com, “despite racking up huge debts, China’s local governments aren’t allowed to issue bonds to help pay them off. Although there is a small trial programme underway, the market is still effectively closed.
However, the ban doesn’t stretch to local government finance vehicles – LGFVs for short – which are technically corporations, even though they do the work of a government body. Bonds issued by LGFVs – called Chengtou bonds – have been booming.”
According to the article, local Chinese governments have been using “Chengtou” bonds as off-balance sheet financing vehicles because they have been prohibited from issuing direct municipal bonds. Yesterday, the Chinese government signaled it is close to allowing 10 local entities (including Guangdong, Beijing and Shanghai) to offer municipal bonds directly to investors. Presumably, this would be the first step toward establishing a full-fledged municipal bond market. As an indication of its potential size, Chinese local governments were reported to owe a total of $3 trillion USD as of June 2013.
As some of you may recall, we had similar hopes for the development of a European municipal market when European monetary unification was introduced at the turn of the century. However, with perhaps the exception of Switzerland, none of the European countries had the decentralized federal government structure necessary to support a true municipal bond market.
Arguably, neither does China, with its centralized, Communist Party-led political system. However, unlike most European countries, the Chinese have, at least on the surface, implemented fiscal decentralization. According to a recent US Congressional study, “(Chinese) provinces have their own revenue streams, and governments at the provincial level and below are responsible for the lion’s share of the country’s public expenditure, including almost all public spending on education, health, unemployment insurance, social security, and welfare. Provinces also have the right to pass their own laws and regulations, which may extend national laws and regulations, but not conflict with them”. Furthermore, provincial leaders have been shown to be powerful players within the Chinese system as they share the same bureaucratic rank as central government ministers.
Needless to say, the first hurdle this fledgling market must overcome is the historical lack of transparency. Chinese officials are saying all the right things in terms of implementing higher standards of disclosure, but the proof will be in the pudding. In the past, the central government has had problems imposing its will onto provincial governments. Perhaps, in time, the capital markets will prove to be the best enforcer of disclosure standards.
Needless to say, the development of this potentially massive new market would be of great interest to anyone who’s currently involved in municipal finance.
As long as you can believe any of the numbers, that is.
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