“Reality: what a concept!” The famous quote from the late, great Robin Williams may well be applicable to today’s municipal market.

The first reality we all have to face up to? This may be as good as the muni market will get for the rest of the year. The combination of a supportive Treasury market, scant new issue supply and now, a temporary break from the Puerto Rico Electric Power Authority (PREPA) restructuring threat, has allowed the tax-exempt market to soar in recent days. As a result, the inter-market ratios now stand at rather uninspiring levels: as of 8/19, the 5-year, 10-year and 30-year ratios stood at 72%, 88% and 97%, respectively.

Detroit Water and Sewer Tender Offer

Holders of the Detroit Water and Sewerage Department (DWSD) debt have also been getting a painful dose of reality. As you may recall, the City’s prior attempt to restructure the terms of the outstanding revenue debt has run into stiff (and justifiable) resistance from its utility bondholders. Even though Kevyn Orr’s team has tried to pay lip service to the protected nature of the revenue debt, everyone (including the rating agencies) saw the DSWD’s efforts for what they really are: a default by any other name. Bonds are not called a fixed-income investment for nothing: even if you promise to pay back 100 cents on the dollar, if you try to reduce the coupon or alter call protection, that is still considered a default.

The current tender offer is an attempt to get around the bondholders’ objections and move the bankruptcy process forward. It does come with a thinly veiled threat that things can get much, much uglier for investors, should they choose not to participate, and this is the best deal they’re likely to get. To minimize potential mark-to-market issues, all the proposed tender prices are reportedly near current S&P/JJ Kenny evaluations (at least as of last week). This doesn’t necessarily mean those prices are fair, of course, since the evaluations have probably been depressed by the City’s recent shenanigans. However, when judged against the prospect of further protracted litigation, bondholders may consider taking the Steve Miller Band’s advice to “Take the Money and Run.” To the extent a challenge of the revenue debt in bankruptcy court can be avoided, this might be in all the parties’ interest.

Bonds are not called a fixed-income investment for nothing: even if you promise to pay back 100 cents on the dollar, if you try to reduce the coupon or alter call protection, that is still considered a default.

As we’ve all seen, anything can happen once you get before the judge, so why run the risk of establishing a bad legal precedent? Furthermore, as detailed in our latest report, the financial outlook for the combined utility system still looks fairly dismal, even post-bankruptcy. And, last but not least, this is as benign an interest rate environment as we’ve seen in months, particularly in the lower grade sector of the tax-exempt market. Since the tender is predicated on Detroit’s ability to issue up to $5.5 billion in refunding bonds to take out the tendered bonds, this might be the City’s best opportunity to float the new debt before the rate outlook changes for the worst.  As an investor, this would also not be a bad time to raise some cash and wait for opportunities to develop in the fall. Unless you are one of those who worship at the altar of the Yield God, in which case you might be tempted by the proposed 5 ¾% yield on the refunding issue (as revealed in recently filed court documents).

PREPA Gets Another Reprieve

While the City of Detroit was busy strong-arming its revenue bondholders, PREPA was able to obtain yet another extension from its line of credit banks through March 31st of 2015. This time, the Authority was also able to get forbearance agreements from most other key stakeholders, including a 60% majority of the bondholders, the bond insurers and even the GDB. As part of the agreement, PREPA gets to use the $280 million in its construction fund as an additional liquidity facility for operating expenses.

In exchange for this temporary break, PREPA will be put on a very short leash by its creditors, with very stringent monthly cash and budget reporting requirements, starting with an initial 13-week cash flow statement. During the forbearance period, PREPA agrees not to default on any principal and interest payment, although it is no longer required to make monthly deposits to the Revenue Fund and Sinking Fund pursuant to the current Trust Agreement. This means we’ll have no idea whether or not debt service will be paid until it gets paid. That said, the January 1st coupon does appear a little safer now, assuming no new major credit event impacting cash flows between now and year end.

The Authority will also be required to: (1) appoint a chief restructuring officer (CSO) acceptable to the creditors by September 8, 2014; (2) submit a new five year business plan by December 15, 2014 and (3) submit a full restructuring plan by March 2, 2015. Since we don’t view the CSO appointment as a really big deal (they probably have somebody from one of the restructuring advisors already lined up), the next credit flashpoint probably won’t be until December, unless PREPA fails to deliver up on the new cash flow and budget reporting requirements it has agreed to in the meantime.

All well and good for now. However, we were more interested in what the potential “outs” may be for all the parties who participated in the agreement. For one, the Bondholder Forbearance Agreement is subject to early termination after January 15, 2015 by forbearing bondholders (including bond insurers) representing only 25% of the bond principal amount. In other words, although it took a 60% majority to get this deal approved, a mere 25% majority can undo it. Furthermore, individual members of the so-called ad hoc group of bondholders will have the right to withdraw from the Agreement under certain default scenarios and also to avoid getting “primed” by any new DIP-style financing.

For its part, PREPA has the option to terminate the Agreement at any time “in the exercise of its fiduciary or statutory duties.” As we told our clients, this gives the Authority an “out” a Mack truck can drive through!

At the end of the day, can you still claim you’re not in restructuring mode when you’re actually hiring a “Chief Restructuring Officer?” That fact alone, if nothing else, should confirm that a restructuring is all but unavoidable for PREPA. In fact, both Moody’s and Fitch have come out with statements to the effect that they believe a restructuring is still in the cards.

On Tuesday, the GDB actually posted the job description for the new CRO post. As we read it, the CRO’s nominal job responsibilities appear to be of a consultative nature, with no real control over the outcome of the restructuring process. Just note how many times he or she is supposed to “work alongside” but not supplant PREPA’s current CEO and CFO.

Be that as it may, this latest development in the Puerto Rico sector should allow muni market participants to breathe a little sigh of relief and enjoy what’s left of their summer.

Next week, we’ll review the current state of the high yield muni market and name the state credits most likely to become the market’s punching bag in the fall (hint: one is on a Prairie, the other thinks it’s a Garden).

Until then, Nanu Nanu.

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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