MainLine West Monthly Review – February 2014

Monthly Municipal Market Credit Review – February 2014

Municipal Market Review:

The municipal market has started the year as an all-star performer led by low issuance and lower US Treasury rates.  We feel this is part of the recovery from the harsh treatment munis were given in 2013. More specifically:

  • Municipal supply is down over 30% year-to-date from 2013 levels. Some analysts are blaming this on the polar vortex. The geographic regions showing the largest drop in issuance (over 80% decreases) are in parts of the country with temperatures that have been much lower than normal. Other parts of the country, where the temperature has been near normal or higher, issuance is up over 4%. Forecasters are estimating issuance will finally get going in March. Whether forecasters are wrong or right, the next 60 days will be telling.
  • The municipal market has outperformed its taxable equivalents. Year-to-date this outperformance is highlighted as follows:

                10-year muni rates have decreased 33 bps versus 24 bps for USD Libor rates.

                25-year muni rates have decreased 44 bps versus 27 bps for USD Libor rates.

2014 has started out with two credit events which continue to play out. These events are as follows:

  • Puerto Rico has been downgraded to below investment grade by S&P and Moody’s. Puerto Rico is now looking to issue $2.5 to $3.0 billion of debt. How the market digests this, and at what level, will be of great interest.
  • A restructuring plan put forth by the city of Detroit appears to be bad for investors holding Detroit General Obligation bonds. How the courts rule on the plan, and how the market views it, could be this summer’s highlight event. We discuss this plan in detail in this month’s credit review.

Investment Strategy Review:

We feel investors should be defensive at this time until issuance thaws out. After a rough year-end, rates have decreased since the beginning of the year, due to a lack of supply and relatively cheap evaluations. If supply picks up, rates may increase. While the long-term fundamentals for the municipal market look good to us, there are current risks that are being hidden by the lack of bonds.

Detroit – No Faith, No Credit

On Friday February 21, 2014, the city of Detroit released its plan on how it intends to restructure its debts and afford life after an over 60% drop in population and incurring $18 billion of debt. The details of the plan are very disturbing for municipal finance and, if approved by the courts, will redefine the general obligation pledge.

Background:

Municipal bond investors and finance students for years have been taught that general obligation bonds are a safer investment than revenue bonds. GOs have always traded at a premium price versus revenue bonds because of the full faith and credit pledge. Morningstar defines the general obligation pledge as follows:

  • Debt instruments issued by states and local governments to raise funds for public works. What makes GO bonds unique is that they are backed by the full faith and credit of the issuing municipality. This means the municipality commits its full resources to paying bondholders, including general taxation and the ability to raise more funds through issuing credit.

Just like anything in politics, the manner by which this pledge is interpreted and executed makes for an interesting case in human nature. In this case, the city of Detroit looks to have defecated on this definition.

Please understand that the city of Detroit is a very unique situation, and that its ability to respect the GO pledge has been devalued due to its severe financial decay. The retraction of the GO pledge, as Detroit is trying to execute, is only a concern when the municipality does not have the capacity to raise the monies (through tax revenues or bonds) needed to support its debt. Detroit does not have a lot of options but to do what it is doing.

MainLine West has been a big advocate of buying revenue bonds as opposed to general obligation bonds. We have always preferred picking up yield to buy a bond backed by a designated source of revenue for an essential service project that is Chapter 9 friendly, versus the pledge of repayment from a group of citizens and politicians. It appears the outcome of the Detroit restructuring process could prove this investment strategy prudent.

MainLine does not advocate Detroit’s plan, nor are we condoning it in this credit report. We are only looking at what we think the impact will be on the municipal market.

The Plan:

The restructuring plan filed by Detroit with the US Bankruptcy Court on February 21, 2014 is highlighted as follows:

  1. Police and fire retirees are to receive 90% of their pension claims.
  2. General city retirees are to receive 74% of their pension claims.
  3. These pension cuts are in place for ten years, at which time if the system is healthy, reductions could be renegotiated.
  4. General obligation bonds, whether backed by an unlimited pledge, or a limited one will receive 20 cents on the dollar. The unlimited backed GOs are bonds that are backed by a separate property tax that was voter approved for the sole purpose of paying off debt. This is receiving the same lien priority as the GO bonds that were not voter approved and do not have separate revenue stream (limited).
  5. Secured bondholders with a specific revenue stream assigned to the back bonds, such as Detroit Water and Sewer Department, will be paid in full, and the revenue backing them left untouched.
  6. Bonds sold as certificates of participation (COPs), that were used to fund the pension plan, will get zero cents on the $1.

 What Does that Mean?

The plan dictates to investors that the full faith and credit GO pledge has no claim above any other and, in fact, it has a lower lien than all pension liabilities. It also means that an unlimited GO pledge, that is voter approved, has the same priority as GO bonds that are considered limited.

The City is in a tough spot as it does not have money to pay all of its creditors. The city had to develop a plan that will leave a lot of claims unpaid. It appears that this plan prioritizes city employees at the expense of the individuals and institutions who bought bonds to support city services.

What’s Next?

The restructuring process is happening quickly, and could be final and approved by mid-summer. Every day the plan is delayed, costs the city and its creditors money. The US Bankruptcy judge has scheduled to hear the case on June 16, 2014 and will decide to approve the plan or not. At this point nobody is happy which probably means it’s a good plan. The city’s general retirees are taking a 26% hit on their income while the bondholders are getting a lowly 20 cents on the dollar, even after the city voters approved to repay them.

We feel the final agreement will not be too different than what is currently proposed except for one possible change. The creditors can propose changes to the deal at any time. Whether the city will agree is open for discussion. We think that the final plan will make one change and allow for a distinction between the unlimited and limited GO pledge. We do not think that funds from the pensions will be reduced, but that the amount set aside for bondholders will be sliced differently. More repayment likely will be given to the unlimited GO bonds than the limited ones. Yet the loss will still be big for bondholders.

The Ramifications on the Municipal Market:

General obligation bonds will no longer represent the gold standard for municipal credit quality. The value of a general obligation pledge is now in question, even if voter approved. Investors will need to have more than a full faith and credit pledge to approve a bond’s credit worthiness. The GO pledge will need to have a statutory lien in place to protect the pledge, especially in those states that allow for the Chapter 9 process. This lien will be needed when a bankruptcy plan is negotiated. Other items of future concern:

  •  Demographics remain the priority when analyzing GO debt. The only reason Detroit creditors are fighting over funds, is because the city has lost 2/3 of its tax base and still has all of its debt. Otherwise a plan could have been put in place to raise more tax revenues and pay creditors.
  • Investors should demand municipalities put procedures in place to resolve a situation if it runs into a liquidity problem and meeting debt service costs. This allows a road map to make the changes necessary to repay bondholders without legal or political interpretation. Without this pre-approved process, the legal and bureaucratic process could impair the municipality’s ability to make timely payments.

The value of the essential service revenue bond is confirmed. Revenue bonds, for the most part, have always provided more income then the GO bond and we felt are better protected in Chapter 9. The Detroit bankruptcy plan and its intent to allow for full repayment of the water and sewer bonds helps to validate this view. The designated source of revenue from fees is undeniable, and unavailable to other entities. This is simple and straightforward, a process even a bankruptcy judge cannot ignore.

Summary:

If the plan is approved as discussed above, the municipal market will go through some pain as it redefines the gold standard GO pledge. There will be numerous downgrades in GO backed debt (also certificates of deposit, and appropriated debt) and yields will increase. The event could create a scare in the retail portion (70%) of our market and produce outflows as investors panic first and understand second. We do not feel this event means that the municipal market will see an increase in defaults, or that general credit quality (debt service coverage ability) is weakening.   This event could be compared to the monoline insurers losing their AAA rating. Investors will need to analyze a general obligation bond’s credit worthiness, instead of just buying based on a full faith and credit pledge.

We would advocate taking advantage of market weakness to purchase bonds backed by essential service revenues in the event that a recalibration of general obligation bonds has an adverse impact on the overall market.

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