MuniLand

Don’t let Chicago’s crisis go to waste

Moody’s cracked the whip and downgraded the rating of Chicago’s general obligation bonds to Baa1 from A3 this week. It’s only a one-notch downgrade, but no American city should wear the scarlet letter of BBB. Chicago’s Mayor Rahm Emanuel is seemingly frozen in place and having a tough time addressing the city’s fiscal problems. His behavior belies his famous 2009 quip to never let a serious crisis go to waste.

Moody’s in its rating comment about the city’s $8.3 billion general obligation and sales tax debt seems to think Chicago is in pretty rough shape:

The negative outlook reflects our expectation that, absent a commitment to significantly increase revenue and/or materially restructure accrued pension liabilities to reduce costs, the city’s credit quality will likely weaken. The formidable legal and political barriers to these actions are incorporated in the outlook.

The State of Illinois’s constitutional protection of pension benefits raises the possibility that any attempt to reduce accrued benefits will be litigated by plan members. Ongoing unwillingness to sufficiently increase revenue ensures that annual pension payments will remain a considerable operating stress while continuing to fall well below actuarially sound contributions.

As such, the city’s financial operations will remain structurally imbalanced and the long-term solvency of the city’s pension funds will be exposed to a significant degree of asset return risk.

Where did all the bonds go?

Long-term municipal bond issuance is shrinking. I don’t need to recite the numbers, just look at the chart above (from Sifma with data from Thomson Reuters).

Municipal tax-exempt bond issuance has been lower than 2008-levels for five years. I wrote last August:

There are many factors that are weighing on issuance, but the primary one is likely to be the higher rate environment. There are other factors like shrinking federal revenues due to sequestration and rising pension and healthcare costs for state and local governments. There has been more active pressure from rating agencies about future liabilities like pensions and a lot of uncertainty about the direction that Congress will take regarding capping the muni bond tax exemption.

Will Puerto Rico sell general obligation bonds?

The New York Times reported that Morgan Stanley is shopping a potential $2 billion general obligation bond deal for Puerto Rico. Bloomberg followed up with a story that had a few more details about the offering that Puerto Rico supposedly has not authorized. According to Bloomberg the possible deal terms are:

The taxable general-obligation deal said to be under discussion would have maturities of at least five to seven years. The funds [hedge funds and distressed debt buyers] would assist the commonwealth as it struggles to turn around its shrinking economy. The discussions have cited possible yields of about 10 percent, the people said.

Let’s break this proposed issue into several pieces:

Taxable: Issuing taxable municipal bonds makes sense because it attracts a broader base of investors (including hedge funds, commercial banks and some insurance firms) outside of muniland that don’t take advantage of the municipal bond tax exemption. But the extremely high interest rate is a signal to any bond investor that the security has very high risk, regardless of its investment-grade rating from the three major raters. So we can rule out banks and insurance companies as buyers.

How much do mutual fund flows affect the muniland yield curve?

Municipal bond yields rocketed up late last May after Federal Reserve Chairman Ben Bernanke commented on the likelihood of quantitative easing being drawn back at the year’s end. Mutual fund investors, spooked by possible losses from rate increases, began exiting muni funds.

S&P Indices does a good job of aggregating yields for all maturities and credit qualities (i.e. 5, 10, 20 and 30 year bonds rated AAA, AA, A, BBB). But a even rich index like S&P doesn’t show us some of the finer movements of the market.

Thomson Reuters Municipal Market Data plotted AAA general obligation bonds maturing in 5, 10, 20 and 30 years. This gives us a more precise picture of yield movements across the interest rate curve over time. You can see the same yield spike that happened in late May and early June in the S&P index.

Selling Puerto Rico Cofina 3.0

 

Richard Larkin is generally positive on Puerto Rico. Larkin is Senior Vice President and Director of Credit Analysis at H.J. Sims. At the Bloomberg Muni Link conference last November, Larkin thought the interest rate that Puerto Rico would have to pay to sell a third lien of its Sales Use Tax bonds (known as SUT bonds or Cofina 3.0) would be around 7 percent. This was pretty much in line with market chatter.

A muniland outlook for 2014

After taking a look back at 2013, here are my predictions for muniland in 2014.

The biggest muniland story this year will be the development of the Chinese municipal bond market. It’s not often that you get to watch a government launch a bond market. And China’s will be massive. From the South China Morning Post:

The [Chinese] mainland’s quest to solve its $3 trillion-and-growing public debt problem by starting a domestic municipal bond market hinges on the one thing officials are most afraid of: transparency.

As markets absorb the results of the latest audit of state finances, Beijing’s long-standing vow to develop a municipal bond market to curtail rapid growth in other types of hidden public debt will take centre stage once more.

Muniland’s ‘Best of 2013’

Some exciting developments happened in muniland in 2013. Here is a round-up:

Best paradigm shift

The Center for State and Local Government Excellence developed a holistic approach to analyzing pension costs for local taxpayers that eschews the current approach of reporting municipal, sewer, library and school pension burdens separately.

The team at The Center for State and Local Government Excellence has set a new standard in how local pension burdens should be reported in financial documents like CAFRs. The center’s new approach for measuring a municipality’s pension burden is to aggregate the direct cost of locally-administered pension plans (both city and taxpayers’ share of costs) and contributions to state teacher and non-teacher plans on behalf of dependent school districts. The aggregated cost is compared to a community’s revenues to understand how much must support pensions.

A lot of previous pension analysis looked at pension plans’ funding levels. This study looks at the cost to taxpayers to support the pension promises they have made.

A deep dive with T. Rowe Price portfolio manager Hugh McGuirk

I had a chat with Hugh D. McGuirk, head of T. Rowe Price’s municipal bond team and a member of their Fixed Income Steering Committee. Mr. McGuirk is also a portfolio manager for the US Municipal Long-Term Bond Strategy at T. Rowe Price. Here is the interview.

Q: Do you do credit analysis in house?

A: Hugh McGuirk: Yes. The T. Rowe Price municipal investment strategy is driven by rigorous, independent fundamental analysis.

Q: Are you finding adequate dealer liquidity when you need to make adjustments to portfolios or cover redemptions?

Could the BRIDGE Act be the solution for infrastructure?

New legislation introduced by ten U.S. senators called the BRIDGE Act acknowledges that the likelihood that Congress will increase the gas tax or other infrastructure grants is “bleak.” BRIDGE would create a new form of government sponsored entity (GSE) called the Infrastructure Financing Authority (IFA).

The proposed legislation, led by Virginia Senator Mark Warner, would create an authority that would operate independently of the federal government to make loans and loan guarantees to projects that have sufficient cash flows to repay the loans.

The key provisions of the BRIDGE Act:

·  The BRIDGE Act includes broad eligibility for funding:

Projects would have to be at least $50 million in size, and be of national or regional significance to qualify. Five percent of the Authority’s overall funding would be dedicated to projects in rural regions, and rural projects would be required to be $10 million in size.

Infrastructure requires funding; Where will it come from?

Twitter was abuzz over a chart that was posted on FT’s Alphaville. Quack, quack, quack went Twitter, we need infrastructure spending to boost the economy! Of course nobody mentioned that Republicans, who recently shut down Congress to prove a point, are loath to increase spending. So where could additional money for infrastructure spending come from?

Here is a quick summary of possibilities.

The U.S. government: The likelihood of increased federal spending on infrastructure is almost zero, unless Congress wants to raise the federal gasoline tax. Congress has not increased the gas tax since 1993, not even to keep up with inflation.

State and local municipal bond issuance: This is where the bulk of current infrastructure spending comes from today. Municipal budgets have been constrained. New municipal bonds issued through the end of October fell 14.9 percent to $262.85 billion, according to Thomson Reuters. It’s not likely that state and local governments have significant balance sheet capacity to issue more debt. Here is the current outstanding municipal debt and how it is distributed (source: Sifma):

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