Puerto Rico’s new liquidity providers


There are plenty of stories about how hedge funds are being lured into buy Puerto Rico debt by big dealers. The Wall Street Journal wrote about hedge funds buying distressed debt. Bloomberg reported that Morgan Stanley, Citigroup and Lazard are holding information sessions for hedge funds to learn about Puerto Rico debt. A trader passed me the presentation from the Citi meeting. It was a detailed explanation of the seniority of Puerto Rico debt and the legal covenants and trading history of specific Puerto Rico issuers and authorities. I would guess Morgan Stanley and Lazard did an equally good job on the background for their clients.

Everyone in fixed income markets has been hunting for yield. It’s easy to see how Puerto Rico debt, with its hefty yields, could be attractive to alpha-searching hedge funds. Hedge funds can’t take advantage of the municipal bond tax exemption, so yields for them are not as high as they would be for a risk-loving retail investor. But hedge funds have the advantage of using leverage to buy assets. This leverage usually comes in the form of loans from the hedge funds’ prime broker. Prime brokers are the large dealer banks that provide financing, trading and back-office services to their hedge fund clients. Morgan Stanley is the second-largest prime broker in the U.S. and Citigroup is seventh largest, according to Hedge Fund Alert. These two dealer banks were prime brokers to about 1,800 hedge funds in the first quarter of 2013.

Hedge funds and other buyers that don’t to take advantage of the tax exemption are referred to as crossover buyers. The Federal Reserve does not track the holdings of hedge funds in its “Financial Accounts of the United States” report, (page 98) so we have no official data on how many hedge funds are buying municipal bonds.

There is historical data available from the MSRB and Sifma showing the most actively traded bonds. Puerto Rico captured 14 of the top 50 CUSIPs traded in the third quarter of 2012, and 8 of the top 50 a year later. Average trade size increased year over year from $133,747 in 2012 to $618,614.


In 3Q 2012, there were 26,930 Puerto Rico trades among the 50 most active CUSIPs (suggesting retail activity), versus 8,206 trades in 3Q 2013. Trade size quadrupled year over year to $633,000 (suggesting increased institutional trade activity).

Should China build a muni market?

Reuters reported on the possibility that China’s government will take the next step in building a municipal bond market. It seems that local governments in China have accumulated a lot of debt and it needs to moved off their books. From Reuters:

China may decide next month to expand a trial program allowing local governments to sell bonds, in response to concerns that their huge borrowings are largely hidden from view and pose a risk to the stability of the nation’s financial system.

How big is this debt?

Local government debt totals up to $4 trillion or 42 percent of gross domestic product, according to some unofficial estimates, but much of it has been raised via financing vehicles that do not disclose details on the size and health of loans.

Puerto Rico unveils a plan


Puerto Rico’s top public officials held a two-hour conference call on Tuesday that was open to all investors. That may have been a first for the Commonwealth. Previous calls and conferences had been relatively restrictive in who was admitted. The yields on Puerto Rico’s debt have skyrocketed and the Commonwealth’s access into the public debt markets has been basically shut down. The open conference call was a good change of approach.

Bond investors want to hear the facts about Puerto Rico’s fiscal condition and how they will be repaid on their investments. The call made some progress toward that goal.

The economic and fiscal situation in Puerto Rico is still extremely dire. The economy is mired in a six-year malaise that would be worse if the Puerto Rico government had not issued debt to cover government deficits. As the island has moved away from issuing debt to plug holes in the budget, it has simultaneously reduced the amount of fiscal stimulus that has been injected into the economy. The economy shrank 5.4 percent year over year in August. It will likely shrink more as the Commonwealth reduces its deficit financing.

Diluting the MSRB

Muniland’s overseer, the Municipal Securities Rulemaking Board, has a big job keeping the $3.7 trillion municipal bond market in order. The MSRB was first authorized by Congress in 1975 and mandated to have 5 securities firms, 5 bank dealers and 5 public members. It was nonetheless dominated by the views of bank and dealer members, rarely undertaking investor protection initiatives. There was minimal oversight of municipal bond trading and underwriting practices as dealer banks were steering the ship.

After some gruesome muniland disasters like this one detailed by Bloomberg, Congress added law within the Dodd-Frank bill for the MSRB:

Joseph Ambrosini says the deal looked so easy. JPMorgan Chase & Co. bankers told him there was really no risk. All he had to do was sign a public financing contract, and the bank would give $280,000 to his school district in New Castle, Pennsylvania.

The looming battle between Chicago and Illinois


The bankruptcy filing of Detroit has thrust the fiscal health of America’s cities into the spotlight. This is a good thing, because a number of U.S. cities are facing similar problems: Declining populations, rising costs, heavy pension burdens and thin budgets.

Detroit’s pension troubles are not a major contributor to the city’s insolvency, in my opinion, but many are going on to question Chicago’s large pension challenges.

Chicago is in a unique situation where, burdened with enormous pension costs, it is unable to adjust current pension commitments. This is because the State of Illinois has control of the law that applies to Chicago’s pensions. This may sound odd, but it is how muniland works. In addition to state capitols passing revenue to local governments, they often have significant control over the disposition of local finances.

Puerto Rico tweets about bankruptcy

The twitter handle for Puerto Rico’s executive branch is @fortalezapr. Here are some of the tweets from Thursday:

We are in pretty grim times when an investment grade government is tweeting about bankruptcy to encourage people to approve big tax and fee hikes.

Who is in line to finance the $2 billion for the Highway Authority? Good luck with that.

Is the U.S. Treasury bailing out Puerto Rico?

Puerto Rico budget negotiations for fiscal 2014 are in the final stretch for the year’s July 1 start date. A massive $1.5 billion difference between spending and revenues must be closed. Discussion has included expanding the commonwealth’s sales tax to services and transactions between businesses. Local businesses fought hard against this proposal, and eventually, Governor Garcia Padilla switched focus. Reuters explains:

[Puerto Rico Treasurer Melba] Acosta told reporters that policymakers had agreed to scale back by 73 percent the governor’s proposed sales-tax expansion, which was strongly opposed by local businesses. The expanded sales tax will be levied only on a small group of industries and will raise $287 million during fiscal 2014.

To make up for the lost revenue, the government will assess a business tax on gross sales on a sliding scale, depending on sales volume. It is expected to generate $522 million.

Detroit’s 10 cents-on-the-dollar meme

Detroit’s emergency manager, Kevyn Orr, held his big creditor meeting today and presented his Proposal For Creditors Powerpoint (PDF) for how he would like to treat the city’s liabilities. The mainstream media is running with the story that Orr’s proposal will give creditors 10 cents on the dollar, but the proposal is far from having those terms.

The Proposal calls for the following treatment of various classes of debt:

For secured debts:

For the $5.5 billion of secured water and sewer revenue bonds, Orr proposes to issue new bonds with the current full principal amount (with accrued interest) at a lower interest rate (i.e. no haircuts or reduction in principal). (page 101)

For the $411 million of Secured General Obligation Debt (unlimited property tax pledge) Orr says, “Treatment: Subject to negotiation with holders”. So no stated haircut there. (page 104)

Puerto Rico Government Development Bank’s clogged balance sheet

The Puerto Rico Government Development Bank (GDB) has indicated that it could sell up to $2 billion of bonds this year to refinance loans it made to the Puerto Rico Highway and Transportation Authority (PRHTA). These loans on the GDB balance sheet comprise about 24 percent of the GDB’s assets. The PRHTA is a money-losing operation with $4.7 billion of its own debt outstanding. If the GDB is successful in moving these loans off its balance sheet, then the PRHTA could be carrying up to $6.7 billion in debt on a very shaky revenue base.

If you think that you might be interested in participating in a PRHTA bond offering, you really should first talk to Alan Schankel, Managing Director of the Fixed Income Strategy team at Janney Montgomery. He has written an excellent report that looks at the Highway and Transportation Authority. Here are some key takeaways from his report [my comments in brackets]:

    The toll and tax revenue streams securing Highway and Transportation Authority bonds have been pressured by the island’s stagnant economy. [Note that year over year revenues are down] A gross receipts pledge and monthly deposit mechanism represent a strong security framework from bondholders’ perspective, but operating expenses and losses must also be considered in evaluating creditworthiness. [Operating expenses far outstrip revenues after debt service]

    GDB has extended more than $2 billion of short term loans to the authority. The plan is to issue bonds to finance repayment. [In other words, moving the bad loans off their books] Significant revenue increases are needed if the authority is to remain solvent and retain investment grade ratings. [It looks as if revenues would need to increase at least 50 percent to cover operating losses and service additional debt] A series of management stumbles, not typically seen with a $5 billion bond issuer, heighten concerns. [Go on…] It remains to be seen if the political will exists in Puerto Rico to take measures needed to dig PRHTA out of the fiscal hole in which it finds itself. [The political beast rules muniland]

In the breakdown from the PRHTA (page 15), you can see how all revenue streams have fallen over the last five years:

Big muniland haircuts

Are muniland bondholder haircuts a growing trend? Actually, recoveries (the principal and interest that the bondholders recover in a default) have varied a lot, according to a Moody’s municipal default report published in May:

Recovery rates are high but variable. Historical ultimate recovery rates on Moody’s rated defaulted US municipal bonds are generally higher than those for unsecured corporate bonds. On average, the ultimate recovery for municipal bonds was about 60 percent for the period 1970-2012, compared to 49 percent ultimate recovery rate for corporate senior unsecured bonds over 1987-2012. However, municipal recovery rates for the relatively small subset of defaulted bonds are highly dispersed across individual bonds, ranging from full recovery to two cents on the dollar.

When you drill into Moody’s default data, there is only one local government bond default where the recovery was less than 100 percent – the Belfield Limited Tax General Obligation default in 1987 – where bondholders ultimately recovered 55 percent of their principal (page 14). There were also recoveries of less than 100 percent on non-general obligation bonds. The low recoveries were almost always associated with housing or hospitals projects.

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