Muni Market Update (May 7th, 2017): Puerto Rico Files for Bankruptcy

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I am going to attempt a weekly series highlighting some of the latest stories in the muni market as well as reviewing some of the upcoming muni deals. I say attempt because life might get in the way from time to time.

Puerto Rico Files for Title III

Last week, the big story was Puerto Rico filing their version of bankruptcy called Title III. Until Congress passed the PROMESA law last year, Puerto Rico had no path to file bankruptcy or restructuring their debt. An oversight board was assigned to solve what Puerto Rico’s own government could not – $70b in debt and $50b in unfunded pension liabilities. I outlined some of the pension problems in this article.

After Governor Ricardo Rossello failed to come to an agreement with bondholders, the fate of bondholders will be decided by U.S. District Judge Laura Taylor Swain who was appointed by Supreme Court Chief Justice John Roberts on Friday.

GO’s Constitutional Guarantees

There was never going to be an amicable settlement when there were valid arguments from the two largest groups of Puerto Rico bond credits: GO’s and COFINA (sales tax). The GO’s were supposed to be constitutionally guaranteed to be paid ahead of anyone else including the government’s own employees. Yet some of the GO’s have already defaulted.

This is not something you see very often on a Bloomberg screen for a municipal bond:
Puerto Rico Default

This is where the Constitutional guarantee was described in the 2012 Puerto Rico GO bond issue.

Puerto Rico Guarantees

The full Official Statement can be found here.

A first claim should entitle GO bondholders to ANY source of revenue defined as Commonwealth resources. That means before the teachers, the policemen, the utility workers, and even the Governor. Of course that would mean the people of Puerto Rico would lose access to some of the central services provided by the government. Politicians will not allow the people to suffer to pay “greedy Wall Street investors”.

This case will be interesting to watch simply because if Puerto Rico guarantees payment of GO bonds ahead of everything else, how can these bonds be impaired even 1%? Prior to the PROMESA bill, there was no legal means for Puerto Rico to file bankruptcy or restructure but the rules were changed AFTER the bonds were issued.

Investors will now have to factor that into the risk of other municipal investments. Many muni investors assume that U.S. states can not file bankruptcy based on the U.S. Constitution – but given what has happened to Puerto Rico, that doesn’t mean states can’t default.

COFINA’s (PR sales tax) Argument

The COFINA sales tax bond structure was created to provide another way for Puerto Rico to issue debt since their Constitution created a debt limit for GO debt. Debt limits seem like a good idea in practice but politicians (lawyers) can always find a way to cheat the system.

It should be noted  that this section of the OS address the “portion of the sales and use tax allocated to COFINA” and says that it is not “available Commonwealth resources”. This will be the argument that COFINA bondholders will make in that the GO bondholders were made aware the dedicated revenue stream for COFINA was not available to GO bondholders.

PR Debt Limit

Source: Official Statement can be found here.

The last update on sales tax collections came out last year with September data. COFINA’s annual debt service had been fully funded as of January 2016 so for the remaining months of the fiscal year the sales and use tax collection flowed mostly to the General Fund. For the 2017 fiscal year, the total debt service for COFINA was expected to be $708 million. Notice the total sales and use tax collections in 2015-2016 was $2.3 billion, more than 3 times the required debt service for the year. Why should the sales tax bonds be impaired when based on their structure, there is plenty of revenue to cover debt payments?

In addition, there are senior and subordinate sales tax bonds. Subordinate bondholders should take losses before any seniors. Yet, the Puerto Rico Government was essentially offering the same amount for both liens. If the judge decides subordinate bonds recover the same amount as senior bonds, then this precedent will completely change the nature of seniority structures in the muni market or at least senior bonds should trade at the same levels as subordinate bonds.

PR Sales Tax Collections

Source: Puerto Rico GDB

I think the battle between the GO debt and COFINA debt will be very interesting to watch. But enough rambling about Puerto Rico.

Here are a few other Puerto Rico stories to read:

Bloomberg: Puerto Rico Filed for Bankruptcy. Are You Surprised?: Joe Mysak

ZeroHedge: Who Are The Biggest Losers From The Puerto Rico Bankruptcy

SeekingAlpha: Puerto Rico Defaults: Are Illinois And New Jersey Next?

Muni Yields Fall Relative to Treasuries

The chart below shows the 10 year yields for AAA rated munis (white line), AA revenue munis (orange), A revenue munis (blue), and the 10 year treasury (green). We have started off the month with the 10 year treasury rising while muni yields have remained flat or falling for the AA revenue group. This makes munis less attractive but relative to other fixed income products (corporates, agencies, mortgages) they are still the best value.

Muni Yields

The change in the muni and treasury yield relationship is pronounced in the chart below, especially for shorter munis. This ratio can be used as a relative value indicator – when the ratio is higher, it is generally a better time to buy munis.

For shorter muni bonds, this is approaching the lowest level the ratio has been over the past year. This can be explained by two factors:

  • Short-term rates are rising due to the Fed’s rate hikes
  • A rising rate environment leads to increased demand for short duration bonds

White Line: 30 year muni yield as % of the 30 year treasury yield

Orange Line: 10 year muni yield as % of the 10 year treasury yield

Blue Line: 10 year muni yield as % of the 5 year treasury yield

Muni-Treasury Ratio

Muni Deals this Week

Here are some of the top muni deals on the calendar this week. It is notable that most of these are negotiated deals and tend to be offered cheaper than competitive deals. In competitive deals, dealers bid for the deal which usually means lower yields for investors. In negotiated deals, muni issuers agree to work with an investment bank to sell a deal at a pre-determined rate.

Issuer DescriptionStateAmt (MM)
CUYAHOGA CO -REF REVOH915.06
HOUSTON ISD - REFTX837.8
HAWAII -FKHI575
LA PUB FACS AUTH- REV LA412.02
MET TRANSPRTN AUTH -NY300
SAN FRANCISCO BAY ARECA280.89
SOUTHERN CALIFORNIA MCA245.165
HAWAII -FN -REFHI230.87
LOS ANGELES -A -REVCA228.58
OAKLAND USD-REFCA221.435
NEW ORLEANS AVIATION BLA220.88
WI ST ENVRNMNTL IMPT WI202.3
FL DEPT OF MANGMT SRVFL187.825
DENVER CITY & COCO173

One area to keep an eye on is the AMT muni market. As part of Trump’s tax proposal, he has indicated eliminating the AMT tax. AMT bonds trade at higher yields since they are subject to the AMT but if the AMT is eliminated they should trade at yields comparable to other Federal tax-exempt munis. This means there is potential upside for AMT bonds from the proposed tax changes.

Muni Fund News

A lot of folks ask for recommendation on muni funds – particularly closed-end funds. Unfortunately I can not provide investment advice since I am not an investment adviser. What I can do is provide analysis and general market commentary.

Since Puerto Rico has been the focus, I think it is worth looking at funds that have high exposure to Puerto Rico. I previously discussed Oppenheimer Funds high exposure to Puerto Rico debt.

I noted that some of the funds designated as state funds for New York, New Jersey, Virginia, Pennsylvania, and California have over 30% of the fund in Puerto Rico Bonds.

Interestingly, year to date some of these funds have outperformed the broader muni market.

ORVAX – the Oppenheimer muni fund for Virgina has rallied 6.7% YTD and the total return (including dividends) is up to almost 9%. This fund has 29.9% allocated to Puerto Rico.

OPATX – the Pennsylvania fund, which has 31.5% exposure to Puerto Rico has provided a total return of 5.76% YTD.

Meanwhile MUB, which I used as a proxy for the broad muni market has provided a total return of 1.74%.

Since the Puerto Rico bankruptcy announcement, the Oppenheimer muni funds are down very slightly.

PR Oppenheimer

In addition to Oppenheimer, Franklin Templeton Investments also have substantial exposure to Puerto Rico. They released a statement for investors on May 1st.

I personally have no exposure to Puerto Rico bonds or funds with Puerto Rico bonds.

Conclusion

I would love to hear from readers that found some of this information helpful or have recommendations on what to cover in future updates. Since most readers are on the retail investor level and I invest for an institution, I am not completely in tune with the retail muni market. I typically buy $500k+ par value of bonds at a time whereas a retail investor might buy 5 or 10k par value. Please post your thoughts in the comments.

 

 

 

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