Geopolitical events are, first and foremost, human tragedies. So it’s only appropriate for us to start this week’s column by sending our thoughts and prayers to the victims from both sides of the Gaza conflict, as well as those unfortunate passengers of Malaysia Airlines MH17.
Geopolitical uncertainties are certainly behind the latest drop in Treasury yields to a one-year low. The benchmark 10-year bond has broken out of its 2.50-2.70% trading range and is holding around 2.47% at this writing.
The municipal market was able to regain some relative performance against Treasuries over the last few days, as investors were encouraged by a recovery in mutual fund flows and a rebound in Puerto Rico bond prices. Whether the recent PR rally will turn out to be just a “dead cat bounce” from oversold levels remains to be seen, however.
As you may have heard, our friends at NewOak Capital, a leading bank consulting firm, recently released a recovery model for PREPA. The model can be downloaded for free (yes, you heard that right) from NewOak’s web site and it allows you to input your own assumptions for key parameters. We are planning an exciting market event with NewOak and other independent market experts such as Oxford Advisors, Chapman Strategic Advisors and Diver Solutions, so look for an announcement over the next few days.
In terms of potential risks to the market, we continue to keep a wary eye on tobacco settlement bonds. Last week, RJ Reynolds announced it would acquire rival Lorillard Inc. in a cash-and-stock deal valued at $27.4 billion. If you recall, back when the Master Settlement Agreement (MSA) was signed, there were four signatory companies: Philip Morris, RJ Reynolds, Lorillard and Brown & Williamson. The latter then got absorbed into RJ Reynolds just about 10 years ago. With this latest consolidation between the second and third largest tobacco manufacturers, only two signatory companies are now left to support the MSA: Altria (the domestic side of the former Philip Morris Co.) and RJ Reynolds. This means that the security for tobacco settlement bonds is now concentrated in only two firms.
In terms of potential risks to the market, we continue to keep a wary eye on tobacco settlement bonds.
To be fair, tobacco industry consolidation per se shouldn’t matter much to tobacco bond investors if the overall volume of cigarette shipments is not affected. However, the latest M&A activities may be viewed as a response to the rising threat from e-cigarettes and other alternative nicotine delivery devices. If Big Tobacco sees its salvation in something other than traditional cigarettes, that would not bode well for tobacco bonds.
As if to drive the point home, RJ Reynolds Tobacco (RJR) was hit on Friday with $23.6 billion in punitive damages by a Florida state court jury, one of the largest such awards in U.S. corporate and legal history. The verdict was delivered in connection with the Robinson case, one of the so-called “Engle progeny” cases.
“Engle progeny” cases have been heard since a Florida Supreme Court decision in 2006 decertified a $145 billion class-action lawsuit filed by Howard Engle but allowed individuals to file lawsuits blaming cigarettes for their respective health problems. To date, 118 Engle cases have been heard, with about 8,000 cases still pending.
The market is shrugging off this latest development, since the damage award is expected to be significantly reduced upon appeal. However, there is still concern about how large a cash bail RJR will have to post pending appeal.
This latest legal setback for Big Tobacco brings back dark memories of the Price Case (also known as the Lights case) which caused significant damage to the tobacco settlement bond sector more than a decade ago. If you recall, Madison County Judge Nicholas Byron found in March of 2003 that Philip Morris (PM), a unit of Richmond, Virginia-based Altria, misled Illinois smokers about the risks of light cigarettes and awarded $10.1 billion in damages. Even worse, PM was required to post a cash bail for the entire amount, which threatened the company’s very solvency.
Needless to say, tobacco bond settlement bonds sold off dramatically at the time in response to such a devastating verdict. Industry analysts, ourselves included, scrambled to figure out the impact of a Participating Manufacturer’s bankruptcy on the validity of the MSA itself. The tobacco bond sector didn’t fully recover until the award was overturned by the Illinois Supreme Court on December 15, 2005.
Interestingly, the very same Price Case was recently revived in Illinois court. And, as usual, market participants completely ignored it. Let’s hope they’re not up for a rude awakening.
Muni Revenue Bonds: Lessons from Detroit and Puerto Rico
Lately, muni investors have been rushing into revenue debt, which, in the aftermath of Detroit’s assault on the GO pledge, is now viewed as more “secured” debt.
But not so fast. Even in the Detroit case, holders of the City’s $5.3 Billion Water and Sewer bonds have found out, much to their dismay, that special revenue debt is not completely “bankruptcy-secure.” Even though Kevyn Orr and his team is offering to pay bondholders 100 cents on the dollar, they are trying to impair the debt in other ways: a lower coupon rate or a waiver of call provisions, among other things. The problem? Such changes to the bond structure are usually defined as events of default. The mere fact that they’re even being proposed has led all the rating agencies to knock the Water and Sewer system’s debt to below investment grade or “junk” status.
Even in the Detroit case, holders of the City’s $5.3 Billion Water and Sewer bonds have found out, much to their dismay, that special revenue debt is not completely “bankruptcy-secure.”
Given the way the Detroit bankruptcy is going, it’s not surprising that politics is also getting in the way of the utility’s operations. The Water and Sewer’s system recent attempt at collecting from key delinquent accounts by threatening to shut off their water has run into a predictable public outcry. Never mind that the list of delinquent accounts include several golf courses and, believe it or not, the State itself (!)
No wonder the Water and Sewer creditors, including the bond insurers and mutual fund giant BlackRock, are still holding out on any settlement with the City, even as other creditor classes have started to settle one after another.
In PREPA’s case, being viewed as a revenue bond has proven to be no panacea either. As the Puerto Rican debt crisis has progressed, it has become increasingly clear that all roads lead back to the Commonwealth (more specifically the GDB) and that all credits previously thought to be separate and distinct are interconnected through a complex web of receivables and payables. Ironically, as the Commonwealth has now conveniently redefined its “willingness to pay” to only include GO and GO-related debt such as the GDB and Cofina, PREPA has become a prime target for restructuring because it comes closest to being a stand-alone enterprise (aside from PRASA). This has made it easier for the Commonwealth to distance itself from the utility, since, by definition, it’s supposed to be self-sufficient. Never mind that it’s been relying on liquidity infusions from the GDB for years…
As you may have heard, the Commonwealth has finally responded to the Franklin/Oppenheimer lawsuit challenging the constitutionality of the Recovery Act. It has asked the Court to dismiss the suit as “unripe and premature,” among other reasons. What does this mean? It means that, until a public corporation actually uses the Act, the court can only render an advisory opinion, which it is forbidden to do. Since PREPA has yet to make a move, the PREPA bondholder claim should be thrown out as “premature.” Again, never mind that PREPA may only be a few weeks away from actually filing under Chapter 2!
PREPA’s revenue debt status could also come into play as the Commonwealth tries to argue its right to pass its own restructuring statutes, as long as they don’t conflict with federal law. Unfortunately, the case law cited by PR’s attorneys appear to deal only with unsecured, not secured debt. “PREPA’s bonds are revenue bonds and thus considered a secured debt. This difference could be a problem for Puerto Rico’s argument,” MuninetGuide Co-Publisher Jim Spiotto said in a recent Bond Buyer article. Jim also pointed out a potential Catch-22 situation for PREPA creditors. They can’t challenge the Recovery Act before a public corporation uses it and they may not be able to challenge it after a public corporation files “because the law puts a stay on all challenges to itself.” Talk about a potentially twisted situation.
The upshot: in the new muni credit world, investors can no longer rely on broad distinctions such as GO versus revenue debt, Limited Tax versus Unlimited Tax etc…Everything has to be evaluated on its own merit, taking into account the underlying credit’s economic conditions. If the economics make sense to the debtors, they will bend over backwards to make things work. Conversely, when the economics no longer make sense, even the strongest legal covenants won’t keep anyone from defaulting.
In this new “populist” environment, politicians will also be quick to seize upon the “Wall Street versus Main Street” argument as an excuse to favor labor interests over capital. For further proof, just look at how the Detroit bankruptcy case is working out for investors: while pensioners are barely seeing any cutback at all in their benefits, Limited Tax and Unlimited Tax GO bondholders have been forced to accept haircuts of 66% and 26%, respectively.
As we’ve stated may times before, legal remedies are great, unless you have to exercise them. Anyone jumping on the revenue bond bandwagon would do well to keep this in mind.
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