Market Commentary: One Thing Leads to Another

Published May 14, 2019

You know how it goes: you decide to spruce up the guest room by having one chair re-upholstered and then one thing leads to another and you end up repainting the room and the hallway and next thing you know you are renovating the bathroom and replacing all the carpets. Well, one thing has been leading to another on the national and global stages of late with tariffs and sanctions, congressional investigations, presidential campaign announcements, ridesharing IPOs, meatless burgers, next-day deliveries, European elections, sabotaged tankers, and a cargo ship seizure. In the normally sedate municipal bond market, the judicial branch has unexpectedly sent dozens of high grade ratings into something of a tailspin. Although not on par with rocket barrages and missile tests, the U.S. Court of Appeals for the First Circuit, the smallest of the 13 federal appellate courts, recently ruled on a case involving a Puerto Rican governmental authority that has caused research analysts and rating agencies to rethink decades of municipal bond credit fundamentals and re-consider the value of special revenue debt.

The case stems from a suit filed by Assured Guaranty Corp and three other bond insurers in the U.S. District Court for the District of Puerto Rico claiming that bondholders have a protected pledge of the special revenues of the Puerto Rico Highway and Transportation Authority, that debt service payments secured by the Authority’s dedicated toll and excise tax revenues cannot be diverted and should continue uninterrupted during bankruptcy proceedings. The Court ruled that such payments are voluntary rather than mandatory, and bond lawyers across the country fell off their swivel chairs. Such was not the case in the Detroit bankruptcy or in any case recalled in the past 30 years. So bond insurers appealed, optimistic that the decision would be overruled. But on March 26, the First Circuit upheld the decision, finding no ambiguity in the language in the bankruptcy code, thereby instantly redefining and reinterpreting the value of special revenue bonds.

The two court rulings have sent shockwaves through special revenue bondholders, bond counsel, and public finance bankers across the country. The plaintiff bond insurers may make further appeals. In the meantime, although the rulings are said to affect only those in four states and Puerto Rico under the First Circuit’s jurisdiction, portfolio managers along with analysts at Fitch, S&P and Moody’s are reviewing their ratings of all revenue bonds secured by utilities, transportation, sales and other dedicated and special taxes that have been found to be not so special after all. Dozens of special revenue bonds are under review for downgrade and on negative credit watch. Traders now need to consider the credit of sponsor governments in evaluating so-called priority lien revenue bonds. Bankers may now need to structure lockboxes and independent collection mechanisms. Issuers of certain school, water and sewer, healthcare, toll road and other bonds with pledged special revenues will likely be paying higher rates.

In other market cycles, tax-exempt bond-buyers might retrench as a result of this apparent industry upheaval. However, unusual conditions prevail and buyers present unrelenting demand for all kinds of municipal bonds. Last week, the muni slate totaled $6.1 billion and buyers had to pay up again for offerings in both the primary and secondary markets. The Maryland Economic Development Corporation sold $103.2 million of Baa3 rated revenue bonds subject to the alternative minimum tax priced at 5.00% to yield 3.25% in 2049. The South Carolina Jobs-Economic Development Authority issued $12 million of non-rated revenue bonds for Lexington Memory Care due in 2054 priced at par to yield 7.25%. The Phoenix Industrial Development Authority brought an $8.3 million non-rated charter school deal for the Leman Academy of Excellence at Oro Valley structured with a 2054 term bond priced at 5.00% to yield 4.82%. And the Oregon Facilities Authority had a $5.2 million transaction for Howard Street Charter School that had a final maturity in 2055 priced at par to yield 5.25%. This week, the $6.75 billion calendar includes a $50 million non-rated Florida Development Finance Corporation solid waste disposal revenue bond issue for Waste Pro USA.  The Denver International Business Center Metropolitan District No. 1 has a $35.1 million BBB-minus rated financing. The Ocean Highway and Port Authority of Florida is bringing a $28 million non-rated port facilities revenue bond deal for Worldwide Terminals Fernandina. And the California Statewide Communities Development Authority has a $20.4 million non-rated infrastructure program revenue bond issue for Pacific Highlands Ranch.

Municipals have really outperformed in this environment of elevated demand and limited supply. The 2-year AAA general obligation yield at 1.53% is 2 basis points below where it began the month. The 10-year yield has fallen 11 basis points to 1.75% and the 30-year at 2.43% is 12 basis points lower. Investors have stretched the string of inflows into municipal bond funds out to 18 weeks, adding $4.2 billion in the last fortnight, $805 million of which has flowed into high yield funds, while taxable fixed income bond funds have taken in $6.9 billion and equity funds have seen outflows of $8.4 billion. The seesaw in the U.S.-China trade talks has led to a selloff in equities and produced a renewed focus on bonds. At this writing, the Dow is off 650 points and the Nasdaq has lost 178 since the start of May. Oil is down $2.25 per barrel to $61.66 while gold prices are up more than $2 an ounce to $1,286. The 2-year Treasury yield has remained in the range of 2.26%, but the 10- and 30-year yields have strengthened by 4 basis points to 2.46% and 2.88% respectively.

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