Market Outlook

As we headed into the long holiday weekend, there was a definite feeling among muni market participants that the Puerto Rico (PR) crisis has now entered a critical new phase, and that the attendant uncertainty could once again derail all the positive market momentum built up during the first half of this year. As we’ve pointed out over the past two weeks, the tax-exempt market’s tremendous rebound year-to-date has also left it vulnerable to a correction.

And the correction did come this week, with muni yields rising in the face of stable-to-declining Treasury rates. Given the potential volatility of the PR situation, muni buyers appear to have wisely decided to either retreat to the sidelines or lock in some of their profits to date.

As a result, muni ratios have cheapened again. The 5-year, 10-year and 30-year ratios have surged to 75.80%, 93.12% and 100.57%, up 2.1, 3.4 and 2.75 percentage points, respectively, from their levels at the end of June.

The S&P Municipal Bond Puerto Rico Index has also given up all its year-to-date gains (-0.28% through 7/9/14), and is down -18.04% over the past year. Interestingly, the S&P Municipal Bond Puerto Rico General Obligation Index has held up much better with a 7.71% year-to-date gain and a more moderate decline of only -11.53% over the past year.

Last week, PREPA did manage to pay its July 1st coupon, much to the market’s relief. But was it, as some market observers have speculated, forced to tap into its debt service reserve fund (DSRF), which would constitute an event of technical default? Not so. We took a closer look at their numbers and concluded they had enough cash on hand to cover the debt service payment. In any event, a draw on the DSRF would have triggered a material event notice on EMMA by now. [Update 7/10/14, 4:30pm EST: Well, it looks like we were wrong: the bond trustee just reported on EMMA an unscheduled draw on the DSRF of $41.6 million. Apparently, PREPA failed to make on June 25th its monthly deposit into the Bond Service Account and Redemption Account. So, contrary to what we initially reported, an actual event of technical default did occur. We do apologize for the error, although this only goes to show how hard it is to get a real handle on PREPA’s numbers. Our calculations were based on reported financials as of 4/30. And they waited until the very last day of the 10-day grace period allowed by the MSRB to report this unscheduled draw!]

Technical default or not, PREPA remains on track to be the first public corporation to make use of the new local bankruptcy law, assuming the latter survives its constitutional challenges. Although the Authority was able to defer its July line of credit payment until the end of the month, it’s a near certainty that it will need some kind of liquidity relief by mid-August (For details, see our update report: “PREPA: A Liquidity Snapshot”).

The rating agencies’ sweeping downgrades of the PR public corporation issues were certainly justified by the passage of the Public Corporation Debt Enforcement and Recovery Act. Unfortunately, the Commonwealth’s concurrent attempt to “ring-fence” its G.O. and Cofina credits appears to have backfired, at least for the time being.

Investors were most rattled by Moody’s downgrade of Cofina, whose senior lien bonds are arguably one of the best, if not the best-secured credit in the PR debt complex. Because Cofina bonds tend to reside in more conservatively-managed portfolios, unlike the public corporation debt which is owned by more high yield accounts, Moody’s (and, as of last night, Fitch) potentially hit a broader swath of the market when it took the sales tax-backed bonds to “junk” levels. For the record, we believe such a drastic move is wholly unwarranted at this time. If the agencies have truly lost confidence in the Commonwealth’s “willingness to pay”, why not rate everything “CCC” and be done with it?

Unfortunately, the Commonwealth’s concurrent attempt to “ring-fence” its G.O. and Cofina credits appears to have backfired, at least for the time being.  

In fact, we’ll let the Commonwealth state its own case: “All the steps taken since the beginning of this Administration have been consistent and aligned towards the same goal: to strengthen the General Fund and COFINA while ensuring the self-sufficiency of public corporations that provide essential services to island residents.  Towards this objective, during the past 18 months this Administration has (i) increased the COFINA base rate from 2.75% to 3.50%, (ii) pledged an additional 0.50% of the SUT to COFINA, (iii) expanded the sales tax base in the fiscal year 2014 budget and (iv) for the fiscal year 2015 budget, and pledged to begin charging the SUT at the Commonwealth’s ports.  These measures have increased COFINA’s debt capacity, improved coverage ratios and break-even growth rate scenarios, and resulted in unprecedented SUT growth rates during fiscal year 2014.   We believe that these actions, coupled with the actions to protect General Fund finances, make the COFINA credit stronger than it was when this Administration came into office 18 months ago.” Not a bad argument, we must admit, assuming the Puerto Rican economy doesn’t fall out of bed again in coming months.

By collapsing all the ratings toward the G.O. rating, the rating agencies appear to have concluded that all roads ultimately lead to the Commonwealth, whose historical support for all its debt they now question.  

At this writing, blocks of the Cofina 5 ¼% of 8/1/57 (74529JAR6) have traded as low as 69.625  to yield 7.68%, down 15.625  points and 144 bps higher in yield, compared to the last pre-Moody’s announcement size trade posted on 6/18.

The subordinate lien Cofinas (now B1/A+/BB-) also traded in size on 7/2 at 67 to yield 9.385%, for a 180 bps widening on the week.

With Fitch’s move yesterday, the senior lien Cofina issue is now rated Ba3/AA-/BB-, quite a split rating. While we do expect S&P to follow shortly with its own downgrade, we would be disappointed but not really surprised if they also took senior lien Cofinas all the way to below-investment grade.

By collapsing all the ratings toward the G.O. rating, the rating agencies appear to have concluded that all roads ultimately lead to the Commonwealth, whose historical support for all its debt they now question. Since everything will be trading on top of each other, discerning investors will surely have an opportunity to pick out some attractive relative values once the dust settles. In the meantime though, the old adage about not “trying to catch a falling knife” should apply.

With all the hubbub about PR, it may have been easy to overlook another potentially important turn-of-event that came out of the Stockton, California bankruptcy proceedings yesterday: after sitting through months of testimony and over Calpers’ vehement objections, Judge Klein has left open the door for a potential adjustment of the City’s pension obligations. He did stop short of actually making such a ruling at this time, deferring his decision to another hearing in October. Needless to say, such a decision could have far-reaching implications for many fiscally-strapped cities as they tackle their crushing unfunded pension liabilities.

“Moral Obligation” Redux

As you may recall, we spoke out in an earlier column about the potential ramifications of a failure by the Rhode Island legislature to honor the State’s moral obligation pledge on the infamous 38 Studios bonds. Little did we know at the time that we would get caught up in the entire controversy. Although we did feel the State should take a rating hit if it defaulted on the bonds, we weren’t convinced that the G.O. rating would end up at “junk” level, as assumed by the State’s consultants, SJ Advisors. In fact, copies of our article were reportedly distributed at one of the legislative committee meetings as supporting evidence for the non-payment case, although that wasn’t at all what we advocated. After meeting with the rating agencies, the State did throw in the towel and made appropriations for this year’s debt service payment on the bonds.

We did feel vindicated to some extent when Fitch came out with an opinion that basically agreed with us. As reported by Paul Burton of the Bond Buyer, “Fitch’s June 24 statement acknowledges that a default would harm Rhode Island’s rating. Its insistence, though, that the ratings would not drop to junk counter some of the conclusions in a state-sponsored report by SJ Advisors of Eden Prairie, Minn., that the Ocean State’s rating could drop below Puerto Rico GOs.”

Although 38 Studios bondholders can now breathe easier and enjoy their coupon for another year, the “moral obligation” issue is likely to be revisited again next year, especially if there is a new occupant in the Governor’s mansion come next January.

The tax-exempt market has put in a tremendous performance through the first half of the year. The second half is shaping up to be quite volatile. By the time it’s over, investors may wish they had Tim Howard on their side, defending them against the relentless onslaught of bad news out of a tiny island in the Caribbean.

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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