Headline Risk Returns to the Municipal Market:
Puerto Rico Debt Likely to Face Restructuring
The second quarter ended with Puerto Rico once again making the headlines. On June 29, 2015, the governor of the Commonwealth, Alejandro Garcia Padilla, disclosed publicly for the first time that the island’s debt was “not payable.” The announcement immediately called into question whether the island would default on its July 1 debt service payments of $820 million and $416 million of Puerto Rico General Obligation (GO) and Puerto Rico Electric Power Authority (PREPA) debt, respectively. However, the island was able to make both payments in full. The Commonwealth provided the necessary set-aside deposits to meet the obligations for the GO debt. In the case of the PREPA payment, debt service reserves and financing from bond insurers provided the necessary funding.
Also on June 29th, through an executive order, the governor appointed the “Working Group for the Economic Recovery of Puerto Rico” to address Puerto Rico’s fiscal condition. The group is tasked with producing a five-year economic adjustment plan by August 30th, that’s expected to include a moratorium on debt service and a debt exchange. With over $72 billion in debt outstanding and no current framework in place to restructure its debt via Chapter 9 bankruptcy, negotiations between the creditors and the Working Group will take center stage over the coming months, starting on July 13th.
As these developments have unfolded over the last two weeks, the sector has remained resilient and has not priced in any contagion risks to the general market. While Puerto Rico GO debt issued in 2014 has fallen by approximately 10%, relative valuation levels for tax-exempt municipals have actually remained stable. Since June 26th, tax-exempt nominal yield spreads to Treasuries from 3 to 7years are actually tighter by 1 to 6 basis points (bps), while the balance of the yield curve was unchanged to wider in spread by 1 to 2bps.
Part of the explanation for municipals performing well into the headline risk, is that events in Puerto Rico and in other fiscally-challenged areas of the country (Illinois and New Jersey) have largely been viewed as isolated events. The vast majority of municipal issuers in the market are seeing slow, but steady, revenue growth and have retained a very austere focus in developing their budgets. Consequently, as long as investors continue to believe that credit deterioration is not developing within the broader sector, in the near term, demand should remain firm. We are currently in the strongest reinvestment cycle of the year for coupons/calls/maturities that are estimated to be $59 billion in July and another $48 billion in August.
Relative valuations are also seeing noteworthy support from the slowing in the refunding/refinancing cycle. Average tax-exempt 10 year yield levels during May and June have risen by approximately 30 bps versus rate levels during the first four months of the year. The higher rate environment was the primary catalyst in slowing monthly refinancings by 37% from April to May. If rates remain range-bound around current levels or move higher, we should continue to see a deceleration in issuance patterns for rate sensitive supply. With expectations for favorable supply/demand technicals to continue to develop during the third quarter, we are constructive on the sector and recommend an overweight position to tax-exempts in tax-advantaged accounts.
Gregory A. Bell, CFA, CPA
Principal and Director of Municipal Products
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