Market Outlook

As the month of May comes to a close, the U.S. bond market continues to confound all pundits with a major technical breakout below the 2.50% mark. In fact, the 10-year Treasury yield, currently sitting at 2.41%, a new low for the year, has become a news story unto itself.

In the simplest terms, the current rally may be viewed as a global relative value play. Once the fixed-income markets got comfortable with the QE tapering process, it didn’t take them long to conclude the U.S. Treasury market is the best relative value out there on a risk-adjusted (and currency-adjusted) basis. As tepid as our economic rebound has been (including weather-related negative growth in Q1), it still compares very favorably with the rest of the world, particularly with Europe, which is still in a disinflationary spiral. More importantly, there are still very few signs of incipient inflation, especially in the labor markets.

There may also be elements of a short squeeze here, as many investors started the year being significantly short their benchmark duration and were caught by surprise by the strength in Treasuries.

The ongoing rally in Treasuries has also been a boon to the municipal market, which already enjoys very favorable supply-demand dynamics. Although June has been known to bring a correction in yield levels, market participants are already looking ahead to the June-July reinvestment period.

Of course, with narrowing credit spreads in investment grade issues, this is not the time to lower your guard on the credit front. Many states are actually seeing shortfalls in their revenues versus projections, among them New Jersey.

The ongoing rally in Treasuries has also been a boon to the municipal market, which already enjoys very favorable supply-demand dynamics.

If recent headlines are any indication, New Jersey is trying hard to beat Illinois to the bottom as the worst-rated state in the country. For now, however, the Prairie State is doing its best to hold on to that questionable distinction. The recent legal challenge to last fall’s pension reform package was largely expected and didn’t cause much of a stir in the marketplace. However, the potential expiration of the income tax surcharge is quite another matter. With only a few days left before the end of the current legislative session, Governor Quinn continues to lack the necessary votes to extend the surcharge, which has become a rallying cry for state Republicans during this election year. Faced with a difficult political choice, the Illinois legislature acted in an all too predictable manner: it fashioned an alternative FY2015 budget which assumes no extension of the income tax surcharge but also doesn’t make all the necessary expenditure cuts to match the lost revenues. Instead, Illinois lawmakers are reverting to their usual fiscal gimmicks, such as inter-fund borrowing and increasing the unpaid bill backlog again. Needless to say, market participants will take a dim view of this latest development, leading to potential spread widening on Illinois paper.

New Issue Market

Only a smattering of new issues will come during this holiday-shortened week. Notable offerings include a $784 million of second lien revenue and revenue refunding bonds for Chicago’s Midway Airport (A3/A-/A-), $561.2 million of AAA-rated Massachusetts Water Pollution Abatement Trust state revolving fund refunding bonds and $322 million second lien revenue bonds from the Los Angeles Department of Water and Power.

Liquidity Concerns Return For PREPA

Puerto Rico investors saw their Memorial Day weekend celebrations spoiled by news reports of mounting cash flow problems at the Puerto Rico Electric & Power Authority (PREPA). While PREPA has been our top pick among all PR public corporations for some kind of restructuring (see our 5/15/14 report), we were still surprised by how tenuous the Authority’s liquidity condition has become.

To recap what we heard over the long weekend: the Authority was reported to be running out of cash to pay Petrobras, its main oil supplier, forcing the latter to threaten to cut off further shipments to the Commonwealth. To some extent, PREPA is still paying for the rating downgrade it incurred last year. As a result of the downgrade to junk, its line of credit for fuel purchase was severely curtailed by Citigroup. The Authority had to resort to a $100 million emergency transfer from its Capital Improvement Fund to fund fuel purchases and, quite literally, keep the lights on. According to PREPA’s Executive Director Juan F. Alicea Flores, the GDB is actively helping the Authority renegotiate its credit lines.

Given this latest credit flare-up, the Commonwealth’s financial team is reportedly back in New York this week for another round of meetings with the rating agencies. A follow-up investor conference call may be scheduled for next week, although this is still unconfirmed at this writing.

To some extent, PREPA is still paying for the rating downgrade it incurred last year.

Recent media reports have also highlighted PREPA’s continuing practice of using intermediaries to purchase fuel, even though that program was officially banned in December 2011. By refusing to purchase oil directly through the GDB, PREPA has been incurring unnecessary markups estimated at more than $100 million a year. Even worse, according to Caribbean Business, “PREPA is preparing to enter a long-term purchase agreement for natural gas, but rather than buying direct from the U.S., which has by far the lowest costs, the public corporation is looking in the Caribbean and international markets, where the final price can be twice that of the U.S. PREPA officials are holding up the Jones Act as a barrier to U.S. natural gas, but CARIBBEAN BUSINESS sources say an existing waiver can be updated for natural gas shipments from the U.S. and that it is the usual intermediaries driving the search for more costly natural gas.”

Given these revelations, one has to wonder if the recently passed energy reform act will prove too little too late. On Tuesday, Governor Padilla did sign the so-called “Law of the Reform of Puerto Rico’s Energy Sector,” which mandates, among other lofty goals, full transparency of the rate-setting process, a shift in the fuel mix away from oil and toward natural gas and the establishment of an Energy Commission to regulate the local energy industry, including PREPA.

PREPA was not the only Puerto Rico name in the headlines in recent days. As we reported last week, Doral Bank, the third largest bank on the island by assets, is fighting for survival as it tries to recover about $230 million in tax refunds from the Commonwealth. The PR Treasury has already declared its tax agreement with the bank, which was reached under previous administrations, null and void. According to Reuters, “Melba Acosta, Puerto Rico’s treasury secretary, has said the government was nullifying the 2012 agreement in part because the statute of limitations had run out and because the deal was not recognized in the government’s accounting books at the end of that fiscal year. The government also has said the bank did not provide any evidence proving it is owed that amount for overpaid taxes.” Doral is not taking this decision lying down: it has hired Robert Shapiro, a former Clinton Administration official, to warn investors about the Commonwealth’s “willingness to pay.”

Whatever the merits of Doral’s case, we do agree that PR investors should closely monitor how the Commonwealth deals with the bank’s claim for clues about how it may deal with its own debt. Axios Advisor’s senior analyst Carol Karsten suspects there might be a link between the Doral case and the recent shortfall in corporate tax collections, especially the shortfall in estimated tax payments. If, as a corporate taxpayer, you heard about the Hacienda (the PR Treasury) walking away from a tax closing agreement, would you take the chance of overpaying your taxes and holding any kind of receivable from the Commonwealth? Perhaps not.

Ironically, the Padilla Administration may not be doing itself any favor by driving Doral into bankruptcy and into the FDIC’s arms. San Juan-based litigation attorney John Mudd, one of the few independent legal analysts in PR, was quoted in Caribbean Business as follows: “If the FDIC takes over Doral, it will sue Hacienda over the tax receivables in federal court, and they will win that case faster than Doral’s in local court.”

At the end of the day, this is just another instance of how interconnected everything is in PR: everybody owes everybody else money and all roads seem to lead back to the Commonwealth. Anyone looking for the next credit flashpoint in PR need look no further than PREPA.

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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