This was truly a momentous week in the global capital markets, on several fronts.
First, in its monthly proceedings, the FOMC basically stayed on its cautious tapering course but somehow managed to spook the market into pushing up the expected time frame for rate tightening. As a result, the benchmark 10-year Treasury yield is now squarely back inside its former 2.50-2.70% trading range. Since market expectations of rate tightening affect mostly the front end of the curve, the Treasury curve has also started to flatten significantly.
Away from their monthly FOMC ritual, the global markets were also captivated by Scotland’s exhilarating efforts to gain independence the United Kingdom. Even though this historical referendum failed to pass, the message it sent to 10 Downing Street did come through loud and clear and that may well be its lasting historical legacy. (It also gave many around the world an excuse to wear a kilt and drink more Scotch, so all is good). Who knows, the folks in Texas may well be inspired to revive secession talks!
From our “high yield” perspective, the most interesting deal of the week was the $76 million issue from the Guam Power Authority (GPA).
The equities market, of course, has been fixated by the Alibaba IPO, the largest ever. By its sheer size, this groundbreaking financing lends itself to hype and hyperbola, nowhere more so than on CNBC. Who can resist a global e-commerce play combined with a China play? Nevertheless, we do want to ask a serious question: can you really put your trust in a company named after a guy who stole from thieves, all forty of them?
BBB-Rated Munis Lose Their Allure
The muni market also tried to share in the excitement, as the new issue calendar staged a sharp rebound to about $6 billion, almost double last week’s slate. It certainly couldn’t have been a better environment for the issuers who came to market this week: not only has the market been starved for supply but the Treasury-related correction in yields over the last two weeks has provided muni investors with a relatively more attractive entry point.
Thus, it was not surprising that this week’s offerings were all significantly oversubscribed and repriced with lower yields.
From our “high yield” perspective, the most interesting deal of the week was the $76 million issue from the Guam Power Authority (GPA). Since the so-called specialty State funds are understandably loath to add to their Puerto Rico exposure, there’s quite a bit of pent-up demand for triple tax-exempt investment grade paper and the deal ended up three times oversubscribed. The 2031 term bonds, the longest uninsured maturity, was repriced to yield a 4.19% to maturity, or + 138 versus AAA. We didn’t think we’d live to the see the day when Guam long-term paper would fetch a 4.00% handle yield!
Pricing considerations notwithstanding, we do view GPA’s credit outlook as stable, at least for the time being. In our latest report on GPA, our senior analyst Carol Karsten dubbed the Authority “The Little PREPA That Could, For Now.” Indeed, the similarities between GPA and the beleaguered, and much larger, PREPA are quite striking.
From a credit perspective, GPA faces many of the same challenges as PREPA in terms of oil fuel dependency, very high end user energy costs and a very high debt burden. Like PREPA, GPA is also working to diversify its fuel mix and fund a large capital improvement program to address EPA requirements. And, to drive home the kind of event risk associated with these island credits, an earthquake of 6.9 magnitude on the Richter scale was reported this week off the coast of Guam. Luckily, there was no real damage this time, except for a few power outages, but investors may want to keep in mind Guam’s location in the infamous Pacific Ring Of Fire.
In spite of all that, there is a significant difference in GPA’s favor: the presence of the U.S. Navy as its largest customer. The U.S. Army is also planning to move approximately 4,700 Marines and their families to Guam from Okinawa in the next few years, in an effort to reduce Japan’s current burden of hosting more than 50,000 American service members. It is this stable military presence, coupled with a much more manageable underlying economy, that sets GPA apart from the troubled PREPA.
The Guam Power issue came with the popular high coupon/kicker bond structure that investors deem more defensive in the event of an interest rate increase. However, bear in mind the resulting high dollar price (between 109 and 111, depending on maturity) may exacerbate the bondholders’ potential downside in the event of a credit problem. To mitigate this “premium risk,” investors may want to forgo a little bit of yield and stick with the insured portion of the loan.
In these strong technical markets, it’s also very easy to lose sight of relative values. The “BBB-rated” sector in particular has been a major beneficiary of the investment grade funds’ “reach-for-yield” in the current low rate environment. As a result, the spread between Barclays’ BBB Municipal Index and its AAA Municipal Index has narrowed to just +186 bps at the end of August, its tightest point since the 2008 financial crisis. This stands in sharp contrast to the below investment grade part of the market, where spreads have remained reasonably attractive.
As a case in point, the Savannah College of Art and Design was able to float a new $181 million issue at a spread of about +100, which we consider very tight for a Baa2-rated stand-alone private school.
Nowhere is the distorted relative value picture more evident than in the health care sector, normally viewed as a higher risk area. Even BBB-quality health care paper is trading at very tight spreads, again around +100 vs AAA. Our friend Howard Manning, a senior trader at InCapital, pointed out a couple of examples. Miami Mt Sinai hospital recently came with a Baa1-rated issue priced at spreads between 86-90 basis points. Bonds for East Texas Medical Center, a Baa2-rated issue with a Negative outlook, recently changed hands at +106.
As BBB credit spreads continue to compress, total return investors may want to give serious thought to upgrading within the investment grade spectrum. Income-oriented buyers may want to look at the top tier of below investment grade, say in the BB-rated category, for more attractive risk-adjusted income opportunities.
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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