Puerto Rico Related Headline Risk Slows Buying Momentum in Tax-Exempts
The tax-exempt market continued to extend the sector’s strong first quarter performance, with 10-year yields falling another 23 basis points (bps) for the quarter. Very favorable supply/demand dynamics continue to be the driving force behind the sector’s performance. New issue supply continues to run well-below 2013’s pace by 16% or approximately $29 billion. Demand continues to grow as investors have gravitated to the after-tax attractiveness of the sector, given the 24% increase in the highest marginal tax bracket following the 2013 tax hikes and the addition of the 3.8% Medicare surtax on investment income. The favorable technical backdrop resulted in 10-year tax-adjusted spreads tightening by 15 bps for the quarter.
However, headline risk returned to the market at the end quarter, led by the credit events surrounding Puerto Rico. The credit rating agencies put through a series of credit downgrades for Puerto Rican debt following the Commonwealth’s passage of the Puerto Rico Public Corporations Debt Compliance and Recovery Act on June 25, 2014. The law allows for the orderly restructuring of certain public corporation debt such as Puerto Rico Electric Power Authority (PREPA), the Puerto Rico Aqueduct and Sewer Authority (PRASA) and the Puerto Rico Highway and Transportation Authority (HTA). The passage of this law, and the sweeping downgrades that followed, created a wave of selling of Puerto Rican debt out of mutual funds and hedge funds that created near-term volatility in non-Puerto Rican debt, as well. Since June 26, tax-adjusted spreads for the 10-year maturity have widened by 14 bps, as the market absorbed approximately $790 million in mutual fund redemptions in the week following the Fourth of July holiday.
The market now expects that the PREPA credit will be the most likely issuer to utilize the Commonwealth’s restructuring law. The issuer has had a history of liquidity concerns and the authority has two credit lines totaling $671 million that are due to expire on July 31 and August 14. These deadlines are due to create a cloud over the market, as more mutual fund outflows are expected to continue until some resolution to this issue has been defined.
Outside of the headline-risk headwinds, technicals remain very favorable for the next quarter and for the balance of the year. New issue supply is expected to remain well-below historical norms. The primary catalyst for the below-trend issuance will continue to come from the substantial drop-off in refinancing/refunding supply. With current yields in 10-years 66 bps higher than at the start of 2013, year-to-date refinancings through the end of June have plunged by 31% versus 2013’s level. Another component of supply that continues to run well-below historical norms is new money financing for infrastructure-related projects. Year to date, this supply has generated $72.7 billion in issuance, which is in line with 2013’s levels. However, when comparing this level of issuance versus the average from 2002 to 2010, current supply remains approximately 40% below the norm for this category. With state and local revenue growth expected to remain on a slow growth trajectory in line with the slow growth in GDP, there does not appear to be the budget flexibility to increase spending dramatically to support additional infrastructure spending. Consequently, we expect to see new issuance remain in a muted pattern over the balance of the year that should result in the second lowest issuance cycle over the last 13 years.
Current 10-year tax-adjusted spreads as of this writing stand at 91 bps, which is 32 bps higher than the one-year tightest spread of 59 bps achieved on April 18th. While we view this spread level as attractive going into the highest reinvestment period of the year for coupons/calls/maturities (July 1 through September 1), we will look to maintain a neutral positioning in tax-exempts until the market receives more clarity on the events surrounding Puerto Rico. If the market continues to see more volatility and potential spread widening resulting from a continued increase in mutual fund outflows, we would view this widening as a potential entry point to overweight the sector.
Gregory A. Bell, CFA, CPA
Principal and Director of Municipal Products
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