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A worker removes the casino sign of a recently closed hotel in San Juan |
The municipal bond market is in rude health, in spite of deepening uncertainty over Puerto Rico’s debt situation and continuing credit risk in Chicago and Illinois.
According to BlackRock, muni market issuance in December was just $22.2 billion – down 41% year-on-year and 29% below the 10-year average – but demand was strong, with $5.9 billion flowing into funds in the same month.
The asset class outperformed both Treasuries and corporates and emerged as the best-performing fixed income asset class of 2015.
“It’s the most over-valued it has been in seven years,” says Thomas Doe, president of Municipal Market Advisors.
That dynamic has continued into 2016, buoyed by higher demand from managed accounts at wealth managers that need to invest to collect their management fees.
“Come January, when there are a lot of maturing bonds, that leaves them under pressure to reinvest,” says Doe. “The market is not great value now for investors, but they need to put their cash to work.”
Those issuers that are coming to market are therefore benefiting from higher demand and lower rates. For example, Florida Department of Transportation came with a 10-year Aa3 bond in January with a yield of 2.12% and a spread of just 32 basis points over triple-A.
Deep concerns
Not every municipality is enjoying the more positive environment, however.
There are still deep concerns about the credit outlook for the US municipal market. In January Chicago launched a $500 million bond issue, which was priced with a yield of 4.875%, some 229bp over triple-A-rated debt.
The city has $20 billion in unfunded pension liabilities. Meanwhile the State of Illinois has been without a budget since July.
It returned to the market for the first time in 20 months in January, paying yields of 4.27%.
Pennsylvania has yet to pass a budget after a six-month stalemate, while Atlantic City is considering a bankruptcy filing after New Jersey governor Chris Christie vetoed legislation aimed at bolstering the casino resort’s finances. It has a shortfall of $90 million next year – about one third of its budget. The concern is that other municipalities will follow suit.
However, municipal market participants are not fretting about Puerto Rico’s fiscal crisis. “The general market is trying to assess the long-term risks of Illinois and Chicago, but the headlines are full of Puerto Rico,” says Doe. “We now refer to Puerto Rico and its restructuring plans as the Kardashians. Everyone wants to talk about it but there really is no point.”
By that, Doe means that it is clear by now which hedge funds and mutual funds are exposed to Puerto Rico’s debt, and that those invested have made the gamble with the understanding that the bonds could be worthless. “Whether they pay on their debt or not, it’s not really something that will move the markets in any large way,” he says.
The bigger issues for Puerto Rico revolve around whether or not some form of Chapter 9 will be afforded to the territory through US Congress. Puerto Rico does not have access to Chapter 9 of the US bankruptcy code – the provision that allows cities such as Detroit to restructure their debts.
It’s unlikely to happen, says Doe, but if it does it could apply to other territories like Guam and the British Virgin Islands, or even to US states. “If it progresses to that level, it could undermine the perception of credit safety more broadly,” he says.
On January 18, Puerto Rico stated that its fiscal situation was $2 billion worse than it had projected. It has $70 billion in debt.
But, given the lack of credible transparency, the facts are still uncertain.
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Chris Foster, NewOak |
“There is no clarity around just how bad the crisis is,” says Chris Foster, managing director at investment firm NewOak. “It’s in the Commonwealth’s favour to portray its situation as dire so that it will be helped out by the US Congress. Puerto Rico hasn’t disclosed the numbers from fiscal year 2014, let alone fiscal year 2015. Even then the numbers released in the past have been amended since.” It’s not even certain the Commonwealth knows what its situation is. Some bystanders suggest money left the island a long time ago in corrupt dealmaking.
The second issue for Puerto Rico concerns the political aspect of a bankruptcy. With US elections looming, Puerto Rico knows that is has some leverage in appealing to presidential candidates who will be in need of Latino votes.
On the flip side of that, Puerto Rico debt is now predominantly in the hands of US hedge funds – hedge funds that have lobbied Congress to prevent Puerto Rico from having access to bankruptcy, particularly the so-called ‘super Chapter 9 bankruptcy’.
“Confusion reigns because there are two separate dialogues going on at the same time,” says Triet Nguyen, managing director at NewOak. “As a result, the market has been receiving a very mixed message.”
In the frustration, investors are becoming more litigious than was expected. Lawsuits have already started.
“It’s one of the most complex sovereign restructurings in history,” says Foster. “We’re just suggesting people don’t take the headlines at face value but instead do their work. We still believe a consensual plan can be worked out.”
