As we head into the mid-year mark, the municipal market has once again proven its resilience with a head-turning rebound coming on the heels of a disastrous 2013.

Year-to-date through June 17, the S&P National AMT-Free Municipal Index is up an impressive 5.32%, more than recouping all the loss it incurred last year. The S&P Municipal Bond High Yield Index, for its part, has gained an eye-popping 9.69% over the same period.

Much of the rebound is, of course, attributable to a dramatic decline in supply, coupled with a steady recovery in mutual fund flows. According to data compiled by Thomson Reuters, year-to-date issuance is down by almost 25% to $115.14 billion through May 31, from $153.03 billion over the same period in 2013.

The declining muni supply outlook does not, however, bode well for market liquidity or for price discovery down the line. This kind of environment could lead to further retrenchment or consolidation on the broker-dealer side. As a case in point, Lebenthal announced yesterday it is abandoning its municipal underwriting and institutional sales efforts to focus exclusively on retail sales and wealth management. I suspect we may get more announcements of this type over the next few weeks. At a minimum, one would expect the sell side to rely more and more on technology, rather than headcount, to serve a shrinking market. In that context, a renewed emphasis on electronic trading systems would certainly make sense.

… year-to-date issuance is down by almost 25% to $115.14 billion through May 31, from $153.03 billion over the same period in 2013.

Furthermore, with all the cross-market ratios at or below 90% throughout the curve, with the exception of the 30-year maturity at 98.7%, the relative value case for munis no longer looks so compelling. The sector may be more vulnerable now to a tax reform scare, if and when that occurs.

Last but not least, despite its very powerful technical underpinnings, the tax-exempt market still needs a relatively stable Treasury market to maintain its performance to date. As traders await the results of yet another monthly FOMC meeting (while keeping an eye on the latest World Cup results), the bond market continues to be torn between two conflicting dynamics: on the one hand, the unprecedented move by the European Central Bank (ECB) two weeks ago and the geo-political turmoil in Ukraine, Thailand and now Iraq, should keep a lid on any rate on the upside. On the other hand, the U.S. employment picture continues to improve faster than expected (tempered somewhat by a low labor participation rate) and inflation is finally starting to pick up, as evidenced by a CPI reading of 2.1% in May.

Overall, these two factors should roughly offset each other and keep the 10-year Treasury yield locked in a 2.50-2.70% range. So far, any breakout attempt on either side of the range, such as the drop to a 2.41% in May, has proven to be unsustainable. In any case, any change in market sentiment regarding the timing of the Fed’s eventual rate tightening should manifest itself primarily through a flattening of the curve, rather than through a significant rise in long-term yields.

Turning to the fundamentals of the tax-exempt market, it’s fair to say that most of the “systemic” credit concerns raised by Detroit and Puerto Rico have abated by now, another factor that has contributed to the muni rebound this year.

In the case of Detroit, in our humble opinion, creditors have been treated to a reasonably orderly (albeit extremely expensive) bankruptcy process, thanks in no small part to bankruptcy judge Steven Rhodes’ skillful stewardship. Judge Rhodes’ insistence that all parties try to reach settlement among themselves has, in the general scheme of things, yielded good results. Not all the outcomes have been positive for bondholders, of course, but they certainly could’ve been much, much worse. As representatives for the buy side, the bond insurers have done a creditable job avoiding any legal settlement that would permanently impair the claim status of the Unlimited Tax G.O. pledge, even if they didn’t quite get 100% recovery. At this writing, Ambac has reportedly adopted the same tack with its settlement on the Limited Tax G.O. bonds, although details of the settlement, including recovery amounts, have yet to be disclosed.

None of this is meant to downplay the precedent-setting nature of the Detroit case. We certainly saw that, when push comes to shove, “labor” still trumped “capital,” and Main Street still prevailed over Wall Street. Faced with potentially draconian cuts to their benefits, public pensioners were able to tap into their strong political support base and come out relatively unscathed. The bondholders and the insurers have not been so lucky. At the end of the day, the Detroit bankruptcy case should highlight the benefits of negotiated settlements outside of Chapter 9. Any other major city that may, at some point, find itself in similar dire straits, would think twice now before heading down the bankruptcy path.

San Juan by Way of Buenos Aires?

Over the last couple of weeks, we’ve been focusing exclusively on the Puerto Rico situation, and for good reasons: the next six months should prove critical to the island’s future as it seeks to overcome short-term liquidity problems while putting in place the necessary structural reforms to secure its long-term economic future.

Although the Fiscal Sustainability Law was in fact passed by both chambers of the Puerto Rican legislature and signed by Governor Padilla on Tuesday night, the local unions, primarily those associated with the most “at-risk” public corporations (e.g. PREPA and PRASA), are certainly not giving up the fight. Those unions approved a general strike on Tuesday, paving the way to open-ended walkouts. According to Caribbean Business, they also called on PR residents to stop paying their utilities bills. We assume this would apply only to those who have actually been paying their bills, and not to deadbeats such as the PR Central Government, which reportedly owes PREPA some $300 million!

To be sure, PREPA itself just can’t catch a break. For a utility that has been scraping for cash to pay for fuel, the latest Iraq crisis-related spike in crude oil prices couldn’t come at a worse time. With analysts already calling for oil prices in the $125-$150 range, should the situation in Iraq worsen, it becomes more imperative than ever for the embattled utility to renegotiate its lines of credit and develop other sources of liquidity.

S&P basically echoed the same message this morning when it downgraded PREPA to “BBB-” from “BBB”: “If the authority cannot renew the lines and cannot procure supplemental liquidity – either from other banks or from the GDB – we will lower the rating to reflect the lack of necessary liquidity. Our rating has always taken into account the fact that PREPA’s high rates, due to the high cost of oil, preclude their ability to build up a strong level of liquidity, obliging them to rely on either the GDB or outside lenders to fund oil purchases.”

This week, the U.S. Supreme Court ruled against Argentina in its multi-year battle against investors who did not exchange their debt as part of the country’s debt restructuring in 2005 and 2010.

Of course, as was the case with the Commonwealth G.O.s, the threat of downgrade has “circularity” written all over it: if you don’t renew your credit lines, we’ll downgrade you. But if you are under a negative creditwatch, you may find it much harder to renew your credit lines.

In the meantime, the Padilla Administration may want to keep a close eye on one of its Latin neighbors to the South: Argentina. This week, the U.S. Supreme Court ruled against Argentina in its multi-year battle against investors who did not exchange their debt as part of the country’s debt restructuring in 2005 and 2010. The Court rejected Argentina’s appeal of a lower-court ruling that required the Kirchner Administration to pay these so-called “holdout investors” on a pari passu basis with all other bondholders. Since the country currently does not have the resources to pay these additional creditors, the probability of an Argentinian default on all its debt has now risen significantly.

So far, the Buenos Aires government has responded to the court ruling by showing a greater willingness to negotiate with the holdout creditors. In a twist that has direct implications for holders of the last Puerto Rico G.O. bond issue, the government is floating an unprecedented proposal to swap its existing bonds that are governed by U.S. law for debt that falls under its own jurisdiction. If you recall, one of the security enhancements built into the PR G.O. 8.00% of ’35 was an agreement by the PR government to be sued in New York court. Although we don’t purport to be legal experts, this feature may have some teeth in it after all.

As the Commonwealth of Puerto Rico weighs its options regarding its own debt, the Argentinian saga should serve as a reminder of how messy a sovereign debt default could get and what it would be like to have hedge fund creditors chasing its assets all over the globe.

Don’t cry for Argentina, just view it as a cautionary tale.

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