Market Outlook

The recent “risk-off” rally in bonds, driven by geopolitical issues in the Gaza and the Ukraine, has proved short-lived. The benchmark 10-year Treasury has failed to hold below 2.50% and is now back in its familiar 2.50-2.70% range (it closed at 2.58% last night). The reason? Wednesday’s U.S. GDP report showed the economy rebounding from a dismal first quarter to register a seasonally adjusted annual growth rate of 4.0% in the second quarter.

Not that the economy is at any risk of overheating, since growth is still running at a mere 1% for the entire first half. Nevertheless, that didn’t stop market participants from fretting yet again about the potentially accelerated timing of a rate increase from the Federal Reserve.

With the bears temporarily back in charge, both on the equity and fixed-income side, Friday’s July employment report will take on much greater significance, with forecasters looking for another 200,000-plus month.

In the municipal market, yet another new precedent was established in the Detroit bankruptcy case. Although we all heard about AMBAC’s settlement on the Limited Tax GO at 34 cents on the dollar, newly-released details about the settlement have raised quite a few eyebrows. In a new twist, AMBAC stands to get additional money if the City can successfully repudiate its $1.45 billion in pension certificates of participation, which are mostly insured by FGIC. Talk about pitting insurer against insurer, and one class of bondholders against another. We probably shouldn’t expect the management teams of AMBAC and FGIC to be on speaking terms any time soon!

PREPA Dodges Another Near-Term Bullet

Apparently, neither Argentina’s second default in 13 years nor the FOMC meeting could keep market participants away from our first independent expert webinar, titled “PREPA in The Crossfire.” On Wednesday, I was honored to be part of a panel with Gary Krellenstein from Oxford Advisors, Mike Craft from Lumesis, Chris Foster from NewOak Capital and, last but not least, MuninetGuide’s own Jim Spiotto from Chapman Strategic Advisors. We had close to 300 attendees on the call, representing a wide cross-section of the muni investment community as well as many crossover investors. We tried to keep our comments brief (some of us more successfully than others, as yours truly was apparently a bit too long-winded!) just to give the audience more time for Q&A. And it turned out to be quite a lively Q&A!

PREPA’s real problem has nothing to do with debt service (as politicians and union leaders would like to believe) nor with labor costs (as bondholders like to argue).

Generally speaking, most of our audience’s questions centered around PREPA’s fuel conversion efforts and what they might mean to the utility’s operations in real dollar terms. I believe we were also successful in putting some of the numbers in perspective: PREPA’s real problem has nothing to do with debt service (as politicians and union leaders would like to believe) nor with labor costs (as bondholders like to argue). Fuel costs are the real problem, accounting for a stunning 63% of operating expenses before depreciation in fiscal 2013. In comparison, many of the potential “fixes” suggested by the media and other market pundits turn out to be relatively small dollar items that wouldn’t have a very significant financial impact.

There were also some more “incendiary” questions about the GDB’s presumed role in PREPA’s current financial situation, which we steered clear of. Our purpose was not to assign blame, but to encourage a vigorous debate about some of the potential solutions. Overall, I believe that, we, as a group, made a reasonably credible case that there should be no need for any haircut on the debt, as long as all the stakeholders take a pro-active and creative approach to working with the embattled utility on its operational issues. Of course, that’s always easier said than done in a politically-charged environment such as Puerto Rico’s.

Before anything else can happen, PREPA still needs to get past its short-term liquidity problem.

While we certainly couldn’t get to all the questions posed by our audience yesterday, our panel promised to answer some of them in this column next week, so stay tuned (we certainly don’t want to take a page out of Puerto Rico’s webcast playbook and conveniently ignore real questions in favor of pre-arranged ones). In the meantime, for those of you who couldn’t join us on Wednesday, here’s the webinar replay.

Now back to reality. Before anything else can happen, PREPA still needs to get past its short-term liquidity problem. In fact, yesterday (July 31st) was another key date in the utility’s predictable slide toward restructuring. You will recall that the Authority was able to obtain forbearance from Citibank on a $146 million payment (out of a $250 million line) until the end of July. There have been concerns that the Bank will somehow “slit its own throat” by refusing to grant another extension. Since we’ve always viewed August 14th as the real “drop dead” date, such concerns really made no sense to us.

Not surprisingly, PREPA did confirm last night that “the lenders who provide revolving lines of credit used to pay for purchased power, fuel and other expenses have agreed to extend until August 14, 2014 their previously announced agreements to not exercise remedies as a result of certain credit downgrades and other events”.

Obviously, the mid-August timeframe now becomes the next major flashpoint, which is something we’ve been saying all along. After that, according to The Bond Buyer, there is also a $100 million line of credit with the Government Development Bank (GDB), which matures December 31st, with about $41.3 million currently outstanding. And then of course there is the January 1st coupon payment, which bondholders should probably kiss goodbye to right now.

In the meantime, there remains the issue of whether PREPA has replenished the debt service reserve fund to make up for the unscheduled draw on July 1st. A failure to do so may well trigger some remedies for bondholders, assuming they choose to exercise their rights. By the way, the trustee bank’s lack of disclosure about PREPA’s debt account balances has been nothing short of outrageous. We’ve been trying to contact the bank to try to reconcile their internal balances with the numbers officially reported by PREPA as of April 30th, but so far to no avail.

With all eyes strained on PREPA, it’s easy to overlook another equally troubled public corporation, the Puerto Rico Highways & Transportation Authority (PRHTA). As we mentioned in a new report, a PRHTA restructuring could prove even more problematic for the Central Government and the GDB than PREPA.

As we’ve said before, all PREPA’s doing currently is lurch from one liquidity crisis to the next. Time is running out, however, and the next two weeks may well prove critical to the utility’s future.

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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