New austerity and confidence in Puerto Rico


Five months after Puerto Rico officials talked publicly to market participants, they held an investor call on Thursday with over 2,000 people. The call was captured by Storify. Puerto Rico’s previous call in February rallied market enthusiasm for a $3.5 billion general obligation bond offering that was priced on March 8. The March deal, the largest speculative grade bond deal ever done in muniland, replenished the coffers of the fiscally debilitated island.

Now the government is hoarding that cash and taking “swift and decisive” actions to clean up its internal capital structure. It is paying back internal loans between the central government, the Government Development Bank (GDB) and public corporations. Officials said that they had eliminated virtually all interest rate swap contracts at the GDB. They outlined new revenue sources and detailed expense reductions for general government operations.

The government reiterated that it intends to “ring fence” the debts of several public corporations while protecting their constitutionally-guaranteed general obligation debt and sales tax-backed Cofina bonds. An investor group that owns about $3 billion in Puerto Rico general obligation and Cofina debt announced that it supports the government and stands ready to assist Puerto Rico with financing.

At the opening of the call, Governor Alejandro García-Padilla said “our commitment to honoring financial responsibilities of Commonwealth remains unshaken.” Officials seemed confident and committed to imposing austerity on the government’s expenses.

“We believe that rating agencies have seriously misunderstood and misrepresented the intentions of the government,” said David Chafey, president of the Board of Directors of the GDB. Chafey stated that the government had a sufficient “liquidity runway” to sustain its capital needs, but had expected to access the market again in the short term. Chafey said that the GDB is “dedicated to working on a consensual agreement with our creditors.”

Why it is so expensive to trade muni bonds?

Why is it so expensive to trade municipal bonds? We finally have some answers from a long awaited MSRB report on trading in the opaque muni bond market. The study was conducted by former SEC Director of Enforcement Erik Sirri. It maps where bonds go before they settle into retail customer accounts. Every time the bonds change hands, the price is marked higher. In the dark muni market, nobody sees this happening.

Sirri’s study analyzed 43 million trades between 2003 and 2010. Over 73 percent of the muni trades were for less than $50,000.

muni trades

A trade begins when a dealer buys bonds from a retail customer, and then either sells those to another retail customer or trades them to a dealer (who then sells them to a customer). This “inter-dealer” trading can happen 2-10 times before a bond lands in a customer account. The report refers to these as “chains” of trades. You can see how the bonds are marked up between the chains here:

Municipal bond funds will survive a Puerto Rico shakeout

Puerto Rico

Barron’s had a recent story, “Puerto Rico’s Debt Woes Could Spread,” that says, “As mid-year statements go out, muni-fund redemptions could force selling of other credits.” Barron’s author Randall Forsyth wrote:

But the effects of legislation to allow restructuring of the debt of the [Puerto Rico] so-called public corporations continue to ripple through the municipal bond market. Thus far, those ripples have been contained, with little spillover into the broader muni market.

That could change, however, when holders of tax-exempt bond funds — especially the high-yield variety — get their June 30 statements. How these individual investors react to the funds’ declines from their exposure to Puerto Rico debt could hit the broader muni market if funds are forced to liquidate bonds to meet shareholder redemptions.

Closing the door on the first half of 2014

U.S. Censys Bureau

The first half of 2014 was positive for muniland after a very tough 2013, but weak spots still remain.

Muniland relies on state and local government revenues, which were up slightly for the first quarter. Early indications suggest that the second quarter will also be up (though personal income taxes were off more than expected). The Census Bureau reported that first quarter 2014 tax revenues for four state and local government tax categories increased 2.4 percent to $295.7 billion from $288.7 billion in 2013.

Some states are lagging on the revenue front. The Rockefeller Institute, which tracks state revenues, found seven states that had revenue come in significantly below budget in April:  Kansas, Rhode Island, Vermont, Ohio, Mississippi, Arizona and West Virginia. California revenues weakened in May, but year-to-date they still exceed projections by $1.8 billion, or 2.1 percent. It will take about 45 days until a complete revenue picture is available for the first half.

Puerto Rico’s whirling inferno of news

The news flow from Puerto Rico has become a whirling inferno since the government passed legislation last week to allow some of the Commonwealth’s public corporations to default.

Here are four important points for investors in Puerto Rico bonds:

1. The market is awaiting official confirmation that Puerto Rico’s teetering electric utility PREPA has made its $204 million bond payment due July 1. If made, it will relieve short-term pressure on Puerto Rico, but the intentions for restructuring are still unknown. Attention will turn to PREPA’s $660 million outstanding lines of credit with Citibank and Scotiabank that need to be renewed.

2. The credit rating agencies are finally catching up with the market and have been raining downgrades and watch alerts on Puerto Rico and its public corporations. At this point these downgrades are somewhat irrelevant, since Puerto Rico bonds are selling at junk yields and investors are more interested in possible recovery values.

Puerto Rico ring fences its public corporation debt

Puerto Rico

In a dazzling effort, Puerto Rico Governor Alejandro Garcia Padilla presented legislation to restructure the debt of several public corporations. Both the Puerto Rico Senate and House approved the measure and pushed it to conference where statutes require that it be reconciled by the end of the legislative session on June 30. Seldom have financial markets seen such an elegantly choreographed approach to haircutting sovereign debt.

For months, Padilla has promised a balanced budget for fiscal year 2015, which begins July 1. He maintained that no government employees would be laid off (although contract workers might be). The Commonwealth’s $9.6 billion general fund budget had enormous deficits. By severing the fund from the deficits of Puerto Rico’s public corporations, the general fund will be relieved from financing about $800 million a year. Caribbean Business reported:

Over the past year, the GDB has reiterated that the public debt of the commonwealth should not be seen as a sum of debts to a single debtor, but rather as individual loans supported by various sources of revenues and income, with certain priorities established by law or contract. The officials said the GDB’s message to the market has been consistent in the sense that neither the commonwealth nor the GDB is in the position to subsidize or bail out public corporations and that they need to become self-sufficient.

A revolution in muniland

Goldman Sachs

In a speech last week at the Economic Club of New York, SEC Chairman Mary Jo White set out three new initiatives that will reorder the way fixed income markets serve retail investors.

Congress gave the SEC the authority to regulate fixed income markets in 1975. The initiatives that White announced make up the first broad extension of the SEC’s authority over the murky, cost ridden, over-the-counter bond market. The combined firepower of the SEC, FINRA and the MSRB will likely topple any resistance that dealers will use to protect one of the last remaining profit centers.

In her speech, White pointed out that securities markets operate within a “structure” of regulator rules, technology and market practices. Bond trading information for retail-size trades is often locked in trading venues and available only to select market participants. Transparency for investors is mostly an illusion. White said:

Talking to Robert DiMella of MacKay Shields

I had a chat with Robert DiMella, a senior managing director of fixed income manager MacKay Shields. DiMella brought MacKay Shields to New York Life in 2009 with $400 million of assets under management. He now manages close to $10 billion there. Retail investors typically buy and hold municipal bonds, but mutual fund managers like DiMella get paid to move from overvalued to undervalued bonds and take advantage of market mispricings. I had a peek into his operation.

Choosing bonds is about the underlying strength of the issuer. DiMella’s group references but does not rely on credit ratings. DiMella thinks that there is too much fear of rate increases and, like Blackrock fund managers, he does not think they are likely.

There may be value in more credit-sensitive parts of the market, like non-investment-grade high-yield bonds. The wide risk premiums seen in high yield are not legitimate, according to DiMella, who thinks they come from fears generated by Detroit and Puerto Rico. Investors are less willing to buy high-yield bonds because they are not comfortable with the risk. “Don’t take duration risk, take credit risk,” said DiMella. Translation: buy lower-quality bonds, but not long-dated bonds.

Another tool to make people more comfortable


After the launch of the MSRB’s new price discovery tool on EMMA I chatted with Executive Director Lynnette Kelly about it and other transparency initiatives. Kelly led the launch of the EMMA website in 2008 and she has continued to champion its expansion to increase transparency in the municipal market. Kelly said that the new and better EMMA was “another tool to make people more comfortable owning municipal bonds.”

It’s astonishing how much transparency muniland has today compared to the pre-EMMA days. Back then, finding offering documents for new bond issues meant searching through a diffuse set of document libraries and waiting for a hard copy to be mailed. Trade data was available, but it was in a very crude, unusable form for retail investors. EMMA is much more than bond documents. Here is the official description:

Big data improvements at the MSRB

The fine folks at the Municipal Securities Rulemaking Board, led by director of product management Justin Pica, have launched some fantastic improvements for the MSRB’s market data and bond document platform EMMA.

Navigate to the three new major functions on the site with a CUSIP ID:

1. The ability to see trades for a specific security aggregated for one day with trade count, total par traded and high and low price and yield (top right box).

2. Chart trade prices (lower left box).

3. The price discovery tool allows an investor to compare up to five similar securities from comparable issuers with similar terms and credit quality (lower left box).

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