Market Outlook

The Treasury market continues to provide a reasonably stable backdrop to all fixed-income markets, with the 10-year bond still ensconced, as it has been for a while, in a 2.50-2.70% trading range. Fed Chairwoman Janet Yellen reiterated her low rate message in front of Congress yesterday, although her comments ended up fostering more concerns among market observers about future inflationary pressure.

The municipal market did underperform Treasuries last week as a result of Puerto Rico related selling and record redemptions (for the year) from tax-exempt mutual funds. However, this week’s still modest $5.6 billion calendar should keep any selling pressure well-contained.

Supply is certainly an issue in the high yield muni sector, which is ironic given that $70 billion of Puerto Rico debt now qualifies as “high yield.” Away from PR, however, there isn’t much to satisfy yield-hungry investors at this time. Invesco’s $6.7 billion High Yield Municipal Fund, the third-largest high yield muni fund in the country, is reportedly closing its doors to new investors for that very reason.

Howard Manning, Senior Trader at InCap and one of the industry’s health care experts, points out that health care issues have remained among the most actively traded names in the market, due to a relative scarcity of other high yield names.

Even tobacco settlement bonds, which Puerto-Rico heavy funds tend to sell when they need liquidity, appear to have stabilized.

Lack of supply doesn’t mean credit issues can be ignored, of course. Investors were reminded of that fact this week when details about Ambac and BlackRock’s settlement with the City of Detroit were finally released. The reported recovery rate on the Limited Tax GO bonds was a mere 34 cents on the dollar. No wonder it took so long for them to disclose this.

Puerto Rico Goes On a Charm Offensive

As you may have heard by now, PREPA invaded its debt service reserve fund to the tune of some $41.6 million (about 10% of the fund’s balance) in order to make the July 1st coupon payment. We are still puzzled by this shortfall and are attempting to contact the Bond Trustee for clarification. If the unaudited balance sheet numbers reported by PREPA on its own web site as of April 30th  are to be believed, then PREPA must have missed both its May and June monthly principal and interest deposits to end up with that kind of shortfall. If that was in fact the case, it would’ve been nice if bondholders had been notified of the missed May deposit.

In addition, there might be more at stake than just a “technical default” in this case.

In addition, there might be more at stake than just a “technical default” in this case. The 1974 Bond Trust Agreement for PREPA (or more accurately, its predecessor entity Puerto Rico Water Resources Authority) lists the following as an actual “event of default:”

“(g) any proceeding shall be instituted, with the consent or acquiescence of the Authority, for the purpose of effecting a composition between the Authority and its creditors or for the purpose of adjusting the claims of such creditors  pursuant to any federal or Commonwealth statute now or hereafter enacted, if the claims  of  such  creditors are under any circumstances payable from the Revenues” (Section 802-g)

The recently passed PBC bankruptcy act certainly fits the above definition, don’t you think? Although we do not profess to be legal experts, this may open the door for bondholders to declare an actual event of default, with all the remedies that come with it, including acceleration of all the debt (unlike some of the GO debt, PREPA can be accelerated upon default, based on our reading of the documents).

I guess this hinges on whether or not a proceeding has already been “instituted” through passage of the new restructuring law. It’ll be interesting to see if any of the legal experts representing the bondholders will pick up on this point.

At the end of the day, all this may not matter much as we still expect PREPA to start either a Chapter 2 or Chapter 3 proceeding imminently, probably by mid-August and definitely before the January coupon is due.

Since the passage of the Recovery Act, we, like many of you, have been sitting on quite a few conference calls with legal experts, trying to get a handle on what the new restructuring law really means, how it may work in practice, and whether or not it will survive its constitutional challenges. The most insightful call we’ve heard to date, in our humble opinion, was the one hosted by Canadian equity research firm BTIG , featuring the legal team from Chadbourne and Parke.

In contrast to other legal experts, who tended to get lost “in the weeds,” so to speak, the attorneys at Chadbourne and Parke cut right to the chase and pointed out all the disturbing features of the new law (disturbing from a creditor’s standpoint, that is). A full discussion of these issues, some of which appear to stray significantly from standard U.S bankruptcy practices, would go beyond the scope of this column. However, the one aspect that struck us the most is the fact that the Governor and the GDB appear to have retained significant “control powers” in either a Chapter 2 or Chapter 3 proceeding by a public corporation. To wit, any restructuring filing has to be pre-approved by the GDB. The Bank even has legal “standing” in any Chapter 2 or 3 proceeding and can even direct the hiring of the debtor’s attorneys, among other things. The Governor may also appoint an Emergency Manager to replace the current management of the debtor corporation. As the Chadbourne and Parke team pointed out, these “control powers” would be particularly relevant if the debtors owe significant debt to the Commonwealth or the GDB.

Given that the Commonwealth, acting through the GDB, will have its fingerprints all over any future Chapter 2 or 3 filings by public corporations, its official attempt to “ring-fence” the GO credit and separate it from any public corporation debt restructuring does ring hollow, in our opinion.

And yet, despite all these mixed signals, the Padilla still feels it has been “misunderstood” by the market! In an effort to regain control of the debate about its “willingness to pay” following the recent onslaught of downgrades, the Commonwealth will be going on what amounts to a new charm offensive, starting with another Investor Webcast scheduled for tomorrow, July 18th.

Going into the call, the PR market appears to have found a bottom (at least for now) around the middle of last week. Since then, most actively-traded issues have bounced back nicely. The benchmark PR GO 8.00 of ’35 hit a new low of 84 (9.81% yield) on July 9, only to close at 87 ¾ Tuesday night (still below the pre-Recovery Act high of 90 on June 27th and well shy of the original issue price of 93). PREPA 5 ¼% of ’40 have also bounced off a low of 39.375 on July 2nd to close at 45 ¼ last night (note: we only look at trades of $1 mm or more).

In an effort to regain control of the debate about its “willingness to pay” following the recent onslaught of downgrades, the Commonwealth will be going on what amounts to a new charm offensive …

The Cofina Senior Lien bonds, which we thought were unfairly treated by Moody’s and Fitch, have also rallied from a low of 74.582 (7.48%) on 7/8 to 79.04 (7.01%), a significant 6% gain in a week. Perhaps market participants drew some comfort from the fact that, although S&P has joined the other agencies in downgrading Cofina, they did stop short of taking the issue all the way down to “junk” status.

There is clearly much at stake for tomorrow’s Investor Webcast. The last time PR hosted a public investor call, it was successful in calming the market’s frayed nerves, at least for a while. The Commonwealth is hoping it will be able to pull off that feat once again, although it will be facing a much, much more skeptical audience this time around.

Should the Commonwealth fail to convince investors of its honorable intentions, the latest charm offensive may just turn out to be more offensive than charming.

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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