Puerto Rico’s fiscal restructuring reaches new milestones
- Approval of Puerto Rico’s plan to restructure COFINA bonds is one of several recent developments
- Municipal market has only minimal exposure to PG&E
- Los Angeles Unified School District teacher strike has no immediate credit impact; long-term challenges remain
Puerto Rico moves forward with notable developments
In early February, Puerto Rico’s plan to restructure COFINA sales tax bonds was approved by the District Court overseeing the territory’s bankruptcy. The court determined the settlement agreement was a reasonable compromise and in the best interests of both the Commonwealth and its stakeholders. COFINA bonds represent the largest portion of Puerto Rico’s tax-supported debt at $17 billion and the second consensual debt settlement since the territory filed for bankruptcy.
The restructuring plan, which is the product of a negotiated settlement initially reached with creditors in mid-2018, allocates a reduced base amount of sales taxes to the COFINA corporation to secure the new bonds. A portion of sales tax revenues previously pledged to COFINA will now go back to the government. All creditor classes voted to approve the plan of adjustment submitted to the court in January.
Projected creditor recoveries vary by class. Senior lien bondholders have an estimated recovery rate of 93%, while uninsured subordinate holders have a much lower 56% recovery rate. Existing creditors will eventually exchange their bonds for approximately $12 billion of newly issued senior lien bonds spread across several different maturities. The bond exchange was executed in mid-February and bondholders received a pro-rata distribution of eleven CUSIPS of the new COFINA bonds based on their claim as specified in the negotiated court settlement.
Puerto Rico’s general obligation (GO) debt is the next most important debt obligation to address. Following court confirmation of the COFINA plan, both Puerto Rico’s Fiscal Oversight and Management Board and government reiterated their commitment to seeking consensual agreements with creditors when possible.
However, the government’s recent attempts to invalidate GO bonds may portend a difficult path to an amicable resolution. In mid-January, the oversight board filed an objection that seeks to invalidate all GO bonds issued on or after March 2012. The government argues that these bonds, which account for $6 billion of the nearly $13 billion outstanding, were illegally issued because they breached Puerto Rico’s constitutional debt limit and balanced budget requirement. Because they were illegal at the time of issuance, the government views the bonds as null and void, and would like to essentially wipe out the debt, leaving bondholders with no remedy.
The recent challenge to a portion of Puerto Rico’s outstanding GO debt may primarily be a strategy to coerce creditors into a negotiated agreement, but it is certainly an aggressive move. Negotiations with GO bondholders will no doubt be informed by the recent agreement reached with COFINA bondholders, which serves as a benchmark for other recoveries.
Another important 2019 development was the reversal of a prior ruling on the status of Puerto Rico’s Employee Retirement System (ERS) bonds. In August 2018, the district bankruptcy court ruled the bonds did not have a valid, perfected lien based on two very technical issues. The appeals court agreed with creditors in late January on the existence of the lien, which will likely force the lower court to reconsider the implications of bondholders’ security interest in the bonds.
Puerto Rico will soon begin formulating the fiscal 2020 budget and updating the Commonwealth’s fiscal plan. The Oversight Board’s current schedule envisions certifying a new fiscal plan before the end of April and the fiscal 2020 budget before the end of June.
The recent challenge to a portion of Puerto Rico’s outstanding GO debt may primarily be a strategy to coerce creditors into a negotiated agreement.
PG&E bankruptcy expected to have minimal municipal market impact
Pacific Gas & Electric Company filed for bankruptcy protection on January 29. While the bankruptcy has garnered significant press attention, the impact on the municipal market is expected to be minimal. Municipal bonds represent less than $1 billion of PG&E’s nearly $18 billion in debt outstanding. And $762 million of the $920 million in municipal debt is backed by bank letters of credit, so the actual exposure to PG&E in the municipal market is quite small.
PG&E is faced with large and uncertain financial liabilities associated with the California wildfires, some of which were caused by PG&E equipment. The total liability has been estimated to be as high as $30 billion. Under the current California principle of inverse condemnation, utilities can be held liable for wildfire damages even if they are not found to have been negligent. Given the likelihood of greater wildfire events – thanks to climate change and increased residential occupation of fire-prone areas – this legal issue poses great risk to California’s electric utilities.
In 2018, the California legislature took some steps to mitigate utility exposure to the 2017 wildfires by allowing them to fund liabilities with debt backed by customer surcharges. But it will be critical for the California legislature to take additional steps to address the inverse condemnation issue for the viability of electric utilities in the state.
In addition to the inverse condemnation problem, PG&E faces additional challenges because of questions related to its overall safety culture. The utility is currently on probation because of the San Bruno gas explosion and has been accused of lax safety practices in other areas. As a result, there will be significant political pressure not to bail out the utility on the backs of customers. It appears likely that PG&E will be restructured in some way during bankruptcy, possibly by splitting the company, selling portions of it, or even making some part a governmentally-owned utility.
PG&E is faced with large and uncertain financial liabilities associated with the California wildfires.
Teacher strikes have no immediate credit impact
Teacher strikes are continuing to occur and have garnered much press in 2018 and 2019. The strikes have not led to any immediate rating downgrades and do not automatically indicate a negative (or positive) view in terms of credit. On the contrary, the strikes have led to varying outcomes and the financial or credit impact on school districts is analyzed on an individual basis. At the time of this publication, the Los Angeles Unified School District teacher strike just ended and is discussed in brief below. But other teacher strikes have started or are brewing, such as in Oakland and Denver.
The Los Angeles Unified School District teacher strike lasted 6 days in January and cost the District $150 million in reduced state aid from attendance drops, but also $60 million in savings from unpaid wages to striking teachers. The agreement between the District and the United Teachers of Los Angeles largely includes a 6% wage increase retroactive to the beginning of FY19, reduces class sizes and provides for additional staff hires. The wage increase was already incorporated in the District’s budget, though funding for the increased staff had not previously been budgeted for.
The agreement will only further pressure the District’s strained operations, as it relies heavily on one-time funding sources and reserves. Although additional funding is expected from the state, the sustainability of these additional funds is questionable since Governor Newsom’s budget proposal would provide increased aid for education and pension payment relief over the next few years.
Prior to the agreement, the District submitted a qualified budget status for its first interim report in FY19, indicating it may not be able to meet its financial obligations in FY21 due to an ending balance reserve estimated to fall slightly below the statutory 1%. Due to the qualified budget status, LA County Superintendent of Schools recently assigned a fiscal team to the District in order to address its worsening financial situation and will submit a fiscal stabilization plan by March 18.
Although the strike threw the District into the spotlight, long-term structural pressures remain unaddressed, including declining enrollment and growing pension and health care costs. Without a plan to address these issues, the District’s ability to balance operations will continue to be a challenge.
Federal Reserve is slow to acknowledge shifts
The Federal Reserve (Fed) increased short-term interest rates four times in 2018 to a fed funds range of 2.25% to 2.50%. The December rate increase was the ninth of the recovery cycle. Simultaneously, the Fed is normalizing its balance sheet by allowing $50 billion of Treasuries and mortgage-backed securities to roll off each month without being replaced.
For fixed income markets, debates have centered on the Fed’s communications and intentions for 2019. Many investors believe the Fed has been slow to acknowledge shifts in the economy and inflation. However, the Fed has not wavered on the idea that future rate policy will be data dependent. The market is prepared for a pause in rate hikes in 2019. As of January 2019, fed fund futures markets were indicating a higher probability of the next rate move being a cut rather than an increase.
European Central Bank faces political woes
European Central Bank (ECB) Chair Mario Draghi is dealing with political volatility in Europe. France is wrestling with the Yellow Vest protests, Angela Merkel will not run for reelection and the Italian budget is out of compliance with ECB rules. The Brexit process has been very complicated, to the point of threatening Theresa May’s power. Growth and inflation expectations have declined as Draghi prepares to phase down quantitative easing and keep rates at zero. Growth and inflation are expected at 1.6% for 2019. All this supports the U.S. dollar, a softening commodity process and a higher degree of difficulty in extracting growth from U.S. exports
We believe we are in a slower period of still-positive growth.
Municipal performance reflects changing dynamics
Municipal bond market performance was positive in the fourth quarter, with specific performance drivers changing versus the first nine months of 2018. High quality bonds led the way, while moderate credit spread widening caused high yield municipals to underperform.
The 10-year AAA benchmark municipal yield decreased from 2.58% to 2.28% during the fourth quarter. The 10-year Treasury bond yield decreased from 3.05% to 2.69% after hitting an intra-quarter high of 3.24% in October. The 10-year municipal-to-Treasury ratio was unchanged at 85%, in line with its long term historical average.
Similarly, 30-year AAA municipal performance moved in sync with Treasuries. The 30-year AAA municipal yield decreased slightly from 3.19% to 3.02%, driven by the 30-year Treasury yield falling from 3.24% to 3.02% after an intra-quarter high of 3.46%. This 100% ratio of AAA municipals to Treasuries was common throughout 2018, and is significantly cheaper than its long-term historical average.
Investors are watching for yield curve inversion, waiting anxiously for a signal of recession. This economic expansion appears poised to set a new record of longevity, assuming the economy is still growing in the summer of 2019. The length of the growth period itself gives rise to questions around what might end the cycle.
We believe we are in a slower period of still-positive growth. Since 2008, the U.S. has not experienced a typical boom with the associated imbalances, extending the usual boom/bust cycle. In addition, with core inflation falling below 2%, the Fed has the flexibility to pause prior to an over-tightening. All else being equal, a Fed pause could extend the cycle further.
The municipal yield curve is more positively sloped than others, with steepening in 2018. This largely reflects duration avoidance by individual investors, in addition to borrowers issuing longer bonds to match the lives of long-term infrastructure projects. Even if the municipal yield curve shape remains unchanged, investors may receive greater income and potential total return compensation for extending.
Supply declines while demand holds steady
New issue supply declined approximately 25% in 2018 to $338 billion. This reduction was expected in light of the tax law changes that prohibit tax-exempt pre-refundings of tax-exempt bonds. Refunding supply declined by 58%, while new capital raised for new projects increased by a robust 16%. Municipalities are generally more confident in their cash flows and willing to borrow money to upgrade infrastructure to support economic and population growth. Netting out bond calls and maturing bonds, total debt outstanding actually decreased by more than $120 billion.
Demand was fairly steady through the first three quarters of 2018, but investors gravitated heavily to tax-exempt money market funds in the fourth quarter, as risk avoidance gripped financial markets. Tax-exempt fund flows totaled $5 billion for the year, masking fourth quarter redemptions of -$11.5 billion. Investors may be waiting for the Fed to declare the end of its rate hike cycle, but this timing is usually only known in retrospect. Should the Fed appear more dovish, we believe the municipal market will rally and fund flows will become more positive. We also believe investors generally have not incorporated the true value of municipal bonds’ tax status into their portfolio management planning in light of the new tax law. Demand is likely to improve as this understanding gradually filters through the marketplace.
Investors gravitated heavily to tax-exempt money market funds in the fourth quarter, as risk avoidance gripped financial markets.
Credit spreads narrowed through the first three quarters of 2018, only to widen in the fourth quarter. The widening was mainly due to technical factors, and the overall magnitude was modest. Fund flows were -$11.5 billion in the fourth quarter, which typically widens tobacco bond spreads.
This period was no exception, and tobacco was the weakest performing sector in the S&P Municipal Yield Index at -4.5%. Puerto Rico bonds were the second worst performing segment at -2.90%. This is likely attributable to a combination of profit taking and the fact that Puerto Rico bonds are often more highly correlated to other financial markets given their heavy hedge fund ownership.
Overall, high yield credit spreads ended the year 218 basis points (bps) above the 20-year MMM AAA scale. This is 53 bps tighter for the year, even after giving some performance back in the fourth quarter. Looking at spreads more fundamentally, the economy continues to grow and state and local government tax collections continue to set new record highs. Default rates are trending down and are low overall. For these reasons, we believe the 218 bps of compensation for high yield municipals over AAAs appears attractive heading into 2019.
Defaults remain low and idiosyncratic. $2.2 billion in par value experienced a first-time payment default through the end of September. Of this amount, 68% were municipals issued by First Energy Solutions (FES). We consider FES municipal bonds to be an opportunistic distressed debt situation with high recovery potential. Outside of FES, municipal bond defaults are well under $1 billion year-to-date, representing a very small percentage of the $3.8 trillion municipal market.
Upgrades have numbered 468, while downgrades totaled 418 over the trailing 12 months ending 30 Sep 2018, according to Moody’s Investor Service. Upgrades were on $79 billion par while the downgrades represented $52 billion par (excluding $31 billion of downgrades involving Puerto Rico).
Tobacco bonds slightly outperformed the S&P 500 Municipal Bond Index in December, but resumed their recent trend of under-performance by posting the lowest total return of any sector in January. The second lowest return came from escrowed bonds, whose performance during a period of falling interest rates was constrained by their short average duration (1.94 versus 6.27 years for the index). The transportation sector produced the highest return in January, boosted by A-rated toll road bonds from Colorado, Pennsylvania, Texas and New Jersey.
Treasury Yields and Ratios: Bloomberg (subscription required). Municipal Bond Yields: Municipal Market Data. ICI Fund Flows: http://www.ici.org/research/stats. Municipal Issuance: Seibert Research. Defaults: Municipals Weekly, Bank of America/Merrill Lynch Research, July 7, 2017. State Revenues: The Nelson A. Rockefeller Institute of Government, State Revenue Report, June 2017. State Budget Reserves: Pew Charitable Trust. Global Growth: International Monetary Fund (IMF) and the Organisation for Economic Co-operation and Development (OECD). Standard & Poor’s and Investortools: http://www.invtools.com/. Flow of Funds, The Federal Reserve Board: http://www.federalreserve.gov/releases/ Z1/Current/z1.pdf. Bond Ratings: Standard & Poor’s, Moody’s, Fitch. New Money Project Financing: The Bond Buyer. ReOrg Research. U.S. District Court Memorandum Opinion and Order Approving Settlement Between Commonwealth of Puerto Rico and Puerto Rico Sales Tax Corporation, February 4, 2019.
The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Past performance is no guarantee of future results. Investing involves risk; principal loss is possible. This information does not constitute investment research as defined under MiFID.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
Puerto Rico Urgent Interest Fund Corporation (also known as the Puerto Rico Sales Tax Financing Corporation, or Corporación del Fondo de Interés Apremiante (COFINA)) is a government-owned corporation of Puerto Rico that issues government bonds and uses other financing mechanisms to pay and refinance the public debt of Puerto Rico. Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA) is a 2016 U.S. federal law that established an oversight board, a process for restructuring debt and expedited procedures for approving critical infrastructure projects in order to combat the Puerto Rican government-debt crisis. Puerto Rico Electric Power Authority (PREPA) is an electric power company and the government-owned corporation of Puerto Rico responsible for electricity generation, power distribution, and power transmission on the island. The Municipal Market Data 10- and 30-year insured scales are compilations of the previous day’s actual trades for AAA-rated 10- and 30-year insured bonds, respectively. Bloomberg Barclays Municipal Index covers the USD-denominated tax-exempt bond market. Bloomberg Barclays High Yield Municipal Index covers the USD-denominated, below investment grade tax-exempt bond market. S&P Short Duration Municipal Yield Index tracks the municipal bond market with maturities from 1 to 12 years. Bloomberg Barclays U.S. Aggregate Index covers the U.S. investment grade fixed rate bond market. Bloomberg Barclays U.S. Treasury Index includes public obligations of the U.S. Treasury. Bloomberg Barclays U.S. Government-Related Index includes debt guaranteed, owned and sponsored by the U.S. government; it does not include debt directly issued by the U.S. government. Bloomberg Barclays U.S. Corporate Index is a broad-based benchmark that measures the investment grade, fixed rate, taxable corporate bond market. Bloomberg Barclays U.S. Securitized Index is a composite of asset-backed securities, collateralized mortgage-backed securities (ERISA-eligible) and fixed rate mortgage-backed securities. Bloomberg Barclays U.S. Mortgage-Backed Securities Index is the MBS component of the U.S. Aggregate Index and includes the mortgage-backed pass-through securities of Ginnie Mae (GNMA), Fannie Mae (FNMA) and Freddie Mac (FHLMC). Bloomberg Barclays CMBS ERISA-Eligible Index is the CMBS component of the U.S. Aggregate Index and includes CMBS investment grade securities that are ERISA eligible under the underwriter’s exemption. Bloomberg Barclays Asset-Backed Securities Index is the ABS component of the U.S. Aggregate Index and includes credit and charge cards, autos and utilities. BofA Merrill Lynch U.S. All Capital Securities Index is a subset of the BofA Merrill Lynch U.S. Corporate Index including all fixed-to-floating rate, perpetual callable and capital securities. Bloomberg Barclays High Yield 2% Issuer Capped Index measures the market of USD-denominated, non-investment grade bonds and limits each issue to 2% of the index. The Credit Suisse Leveraged Loan Index is designed to mirror the investable universe of the U.S. dollar-denominated leveraged loan market. Loans are added to the index if they qualify according to the following criteria: The highest Moody’s/S&P ratings are Ba1/BBB+, only funded term loans are included, and the tenor must be at least one year. Bloomberg Barclays Emerging Market USD Aggregate Index is a flagship hard currency Emerging Markets debt benchmark that includes USD-denominated debt from sovereign, quasi-sovereign and corporate EM issuers. Bloomberg Barclays Global Aggregate Unhedged Index measures the performance of global bonds. It includes government, securitized and corporate sectors and does not hedge currency. The S&P AAA Municipal Bond Index is a market value-weighted benchmark index designed to measure the performance of bonds rated AAA by S&P. The S&P BBB Municipal Bond Index is a market value-weighted benchmark index designed to measure the performance of bonds rated BBB by S&P. The S&P Municipal Bond Index is a broad, market value-weighted index that seeks to measure the performance of the U.S. municipal bond market. The S&P Municipal Bond High Yield Index consists of bonds in the S&P Municipal Bond Index that are not rated or are rated below investment grade. The SIFMA Municipal Swap Index is a 7-day high-grade market index comprised of tax-exempt Variable Rate Demand Obligations (VRDOs) with certain characteristics. SIFMA stands for Securities Industry and Financial Markets Association. One basis point equals .01%, or 100 basis points equal 1%.
A word on risk
Investing involves risk; principal loss is possible. Investing in municipal bonds involves risks such as interest rate risk, credit risk and market risk. The value of the portfolio will fluctuate based on the value of the underlying securities. There are special risks associated with investments in high yield bonds, hedging activities and the potential use of leverage. Portfolios that include lower rated municipal bonds, commonly referred to as “high yield” or “junk” bonds, which are considered to be speculative, the credit and investment risk is heightened for the portfolio. Bond insurance guarantees only the payment of principal and interest on the bond when due, and not the value of the bonds themselves, which will fluctuate with the bond market and the financial success of the issuer and the insurer. No representation is made as to an insurer’s ability to meet their commitments.
This information should not replace an investor’s consultation with a professional advisor regarding their tax situation. Nuveen Asset Management is not a tax advisor. Investors should contact a tax advisor regarding the suitability of tax-exempt investments in their portfolio. If sold prior to maturity, municipal securities are subject to gain/losses based on the level of interest rates, market conditions and the credit quality of the issuer. Income may be subject to the alternative minimum tax (AMT) and/or state and local taxes, based on the state of residence. Income from municipal bonds held by a portfolio could be declared taxable because of unfavorable changes in tax laws, adverse interpretations by the Internal Revenue Service or state tax authorities, or noncompliant conduct of a bond issuer. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager.
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