You can go your own way,
Go your own way,
You can call it another lonely day,
You can go your own way,
Go your own way …

Fleetwood Mac

Just a bit of nostalgia to start this week’s column … Last night, we were lucky enough to catch Fleetwood Mac’s reunion tour, with Christine McVie back in the lineup after a 16-year hiatus. As I walked down memory lane with all the familiar songs that formed the soundtrack of my youth, the lyrics to “Go Your Own Way” seemed especially applicable to recent market events.

PIMCO certainly forced Bill Gross to “go his own way.” While the “Bond King” doesn’t have anything left to prove at this point, his abrupt departure from the firm he helped found many decades ago drove home a key point. Forget all the reported internal squabbles and leadership conflicts that make for salacious media coverage. The fact of the matter is that the $200 billion PIMCO Total Return Fund has become unmanageable, due to its sheer size. When your fund has become almost a proxy for the market-at-large, there is little you as an active portfolio manager can do to add value. Thus, by going over to Janus Capital and starting all over again with a tiny bond fund, Bill may end up getting the last laugh. It won’t take much for him to show performance on that kind of asset base.

The municipal market has also “gone its own way” of late, a haven of stability within the more volatile fixed-income environment.

So far, Gross’ departure has sparked a massive reallocation of fixed-income assets among all the global asset managers, leading to increased volatility in certain so-called spread product sectors (such as mortgage-backed securities and, yes, even tax-exempt tobacco settlement bonds) where PIMCO has traditionally been a dominant presence.

On top of the PIMCO-related events, Friday’s stronger-than-expected payrolls number, coupled with significant upward revisions to the prior months’ reports, was not enough to offset flight-to-quality pressure from rising geopolitical concerns, leaving the benchmark 10-year Treasury yield at around 2.44%.

The municipal market has also “gone its own way” of late, a haven of stability within the more volatile fixed-income environment. The recent resurgence in new issue supply has actually helped market liquidity and price discovery efforts and one would expect tax-exempt demand and supply to remain well-balanced as long as the weekly new issue calendar stays within the $5-6 billion range. That said, October can be a tricky month as many mutual funds and several major broker-dealers do have their fiscal year end this month.

What’s in Store For Puerto Rico in Q4?

In the wake of PREPA’s forbearance agreements with its creditors, all seems quiet on the Puerto Rico (PR) front, at least for the time being. September was, in fact, another good month for PR paper. According to index return numbers just released by Barclays, the PR bond complex was up 1.1% in September and up 11% for the year to date. Although PR G.O.s and Cofinas came off slightly last month after a strong August, the big winner was PREPA, which rebounded by 6.1% in September alone.

So what should investors watch out for as we start a new quarter? With no major development expected on PREPA until at least December, we continue to believe that the next credit flashpoint will be the PR Highways (PRHTA), particularly as it may affect the GDB’s already tenuous liquidity position. Everyone we’ve talked to expects something to happen in Q4, perhaps as early as this month.

As you may recall, PRHTA accounts for almost a quarter of the GDB’s loan exposure. The Commonwealth has proposed the issuance of $2.2 billion Puerto Rico Infrastructure Financing Authority (PRIFA) bonds, to be backed by fuel taxes (aka Act 31 taxes), proceeds from which would be used to repay PRHTA loans outstanding to GDB. However, the legislation required to transfer the Act 31 revenues to PRIFA still hasn’t been passed by the PR Senate.

Much is at stake here, of course. American University Professor Arturo Porzecanski’s recent paper and subsequent teleconference on the GDB, while short on fresh insight, did go a long way in reminding us of the Bank’s critical role in providing short-term liquidity to all the PBCs. Back in the 1950s, the GDB acted as a true “bank,” lending money mainly to private enterprises. However, by the 1970s, the Bank had become the lender of last resort to all the public corporations on the island and, in effect, facilitated Puerto Rico’s huge debt buildup ever since.

As Dr. Przecanski noted, “the GDB is by far the largest bank in the United States which is neither a member of the Federal Reserve System nor overseen by the FDIC (…) Since the GDB is vulnerable to a deepening of the crisis in the Commonwealth, and it does not have recourse to a lender of last resort, it poses a systemic risk to the financial system and economy of Puerto Rico.”

Thus, a failure to reliquify the GDB and ring-fence it from such troubled entities as PRHTA could have a dramatic ripple effect on the entire PR bond complex. This is enough to keep me up at night, how about you?

The Bank itself has not made it any easier on investors with its poor disclosure practices. It appears that we get updated GDB cash flow statements only when the Commonwealth needs to access the market. Even if the Bank has been keeping the rating agencies apprised of its status behind the scenes, that still constitutes, in our view, a wholly unacceptable disclosure practice, and one that industry regulators should really take a look at.

Sadly, the Puerto Rican economy still hasn’t turned the corner.

Against this backdrop, the local media are also reporting impending changes within PR’s finance team, particularly with regard to the GDB’s leadership. Both the GDB’s Chairman, David Chafey, and its Interim President, Jose Pagan, are presumably on their way out. Treasurer Melba Acosta is expected to succeed one of them, although Governor Padilla won’t announce any change in Acosta’s role until a court decision has been reached in the Doral Bank case against the Treasury. Should Treasurer Acosta lose the case, an outcome that is widely expected by our local sources, she may welcome a reassignment to the lower profile (relatively speaking) GDB post.

Over the next few days, market participants will be focusing on Puerto Rico’s $900 million tax and revenue anticipation note financing. The Commonwealth has reported on EMMA that the notes will carry a 7.75% coupon,” more than double the coupon on similar notes it has sold in past years to meet short term spending needs,” according to The Bond Buyer. The recent weakness in the benchmark PR GO 8.00% of ’35 could be partially attributable to hedge funds selling bonds to make some room for the new financing. After all, the relative value case for the notes is pretty compelling: aside from the attractive coupon (at a time when AAA-rated entities are paying less than 1.00% for their one-year financing), the proposed lockbox feature and investors’ ability to sue in New York court all add up to a rather attractive package, at least relative to long-dated GO paper. Needless to say, this is all dependent on your individual investment circumstances and degree of risk tolerance.

And there is still much risk here. Sadly, the Puerto Rican economy still hasn’t turned the corner. The Economic Activity Index displayed yet another year-over-year drop in August of -1.1%, even worse than July’s 0.7% decline. Electric power generation, gasoline consumption and cement sales continued to collapse. The only ray of hope here? Non-farm employment seems to have stabilized as private sector job generation is finally starting to offset layoffs in the government sector.

So, although things may appear to be quiet on the Puerto Rico front for now, more potential volatility is lurking just under the surface. As we go down the home stretch for the year, the Commonwealth of Puerto Rico may want to keep singing yet another famous Fleetwood Mac tune to its creditors:

Don’t stop, thinking about tomorrow,
Don’t stop, it’ll soon be here,
It’ll be, better than before,
Yesterday’s gone, yesterday’s gone.

Finally, a note to our faithful readers: This article will be the last to be published under our (somewhat regular) weekly schedule. As you may have heard, I recently left Axios Advisors to take up residence at NewOak Capital. With my new job responsibilities, it will be difficult for me to maintain a regular weekly publishing schedule. Although I do intend to continue to contribute to MuniBond Insights, future articles will be published only as topics of interest may arise. You can sign up with MuninetGuide to be notified whenever a new article has been posted. As always, your past and future support for this column is much appreciated.

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