Municipal Outlook: An Appetite for Risk Amid Low Supply
At a price, investors are still willing to take on municipal credit risk--even from some of the highest-profile and most fiscally distressed issuers.
Troubled Municipal Issuers Tap the Market
As we head into the second quarter of 2014, the municipal market is experiencing very low new issuance supply relative to recent years. Through the end of February, only 1,220 new issuances came to market with a total par amount of $33.1 billion. This represents a 29% drop in issuance and a 26.8% drop in par relative to 2013. Amid this low-supply environment, demand for new paper has been very high, even for some of the riskiest municipal issuers. Over the past several weeks, two of the most high-profile and fiscally distressed municipal issuers--the City of Chicago and the Commonwealth of Puerto Rico--successfully sold general obligation bonds in an aggregate amount of almost $4 billion.
Despite the increasingly negative light shed on these two issuers by media pundits and credit rating agencies alike, the bonds were met with very strong demand. In salient ways, investor demand for these municipal bonds contradicts the credit rating actions on these issuers.
At Morningstar, we still see major credit stressors on both the City of Chicago and the Commonwealth of Puerto Rico; however, it is clear that, at a price, investors are still willing to take on municipal credit risk.
Puerto Rico: $3.5 Billion GO
Puerto Rico remains a hot-button topic in fiscal 2014 as stories about the island's economic malaise continue to dominate headlines and the rampant sell-off of Puerto Rico bonds in 2013 has driven prices to acutely depressed levels. Concerns about the credit quality of the island are well-founded--Puerto Rico has long suffered from economic contraction, structural deficits, and huge debt and pension burdens. These pressures boiled over in February, when all three major credit rating agencies downgraded the commonwealth to speculative grade.
Despite these pressures, Puerto Rico successfully sold $3.5 billion in GO bonds meant to address the island's acute liquidity needs. Strong investor demand upsized the sale from $3.0 billion to $3.5 billion, as the government reported that they received $16 billion worth of total orders from 270 different accounts. The bonds, which carry an 8% coupon with a 6-year call option at par, mature in 2035 and were issued at an 8.727% yield. This offering yield was slightly higher than what we'd seen in comparable Puerto Rico GO bonds recently; for the month of February, uninsured 20-year GO bonds traded at 8.308%. Initial secondary market demand and trading brought yields on the new offering down below 8%, but subsequent activity has driven yields back up to about 8.62%.
The Puerto Rican government expects to receive roughly $3.2 billion in net proceeds from the offering; $1.9 billion of this amount will be used to repay loans from the Government Development Bank, $900 million will be used to refinance short-term obligations and swap termination payment, and $400 million will be used to recapitalize interest.
In a first, the bond resolution provides that bondholders may bring action against Puerto Rico's Secretary of the Treasury in New York courts, instead of Puerto Rican courts, to enforce payment claims. However, even if bondholders are able to obtain a judgment from a New York court or any U.S. federal court located in New York, the lack of official jurisdictional authority means that there is no guarantee that a New York judgment would be enforceable in Puerto Rico. Preliminary offering documents for the new issuance also indicate that there is no collateral securing the GO bonds, and bondholders may not claim any public property of the commonwealth in an attempt to enforce a judicial order. Thus, we don't see any tangible additional protections for holders of this series of Puerto Rico GO bonds.
At present, the inverted yield curve for uninsured GO Puerto Rico bonds signals distress, though yields beyond the 5-year range have actually compressed since the beginning of the year. Still, we continue to view Puerto Rico bonds as highly risky from a credit perspective and suitable only for investors who are willing to stomach the volatility that comes with such a credit.
Chicago: $884 Million GO
The City of Chicago reportedly received $3.6 billion of orders on its $884 million GO bond offering, signaling substantial investor appetite for the Midwest metropolis' debt. City officials upsized the sale from an initial offering size of $400 million due to the demand. With the successful placement of $884 million in the recent sale, the city won't likely return to market with an additional GO bond offering in the spring as originally planned.
Various ratings assigned to the City of Chicago's debt were lowered for the second time in less than a year by Moody's Investors Service in the weeks leading up to this most recent sale. After reviewing the new offering, Moody's downgraded its ratings on Chicago's $7.8 billion of GO bonds and on the city's $556 million of sales tax bonds one notch to Baa1 from A3 and assigned a negative outlook. The negative outlook generally indicates that there's a significant chance that the rating will be lowered again in the near to medium term. This recent downgrade came only eight months after Moody's downgraded the city's GO bonds three notches to A3 from Aa3 in July 2013. Some speculated that the rating downgrade would drive down demand and increase borrowing costs for the city, but this was not the case.
Moody's cited increased concerns over the city's mammoth unfunded pension liabilities for the rating downgrades. Although the city recognizes that its pension issues are extremely pressing, officials argued that, since the beginning of the year, only the rating methodology for reviewing local government credits has changed--and not the fundamentals of Chicago's credit quality. To a certain extent, that's a reasonable point: Moody's new rating methodology places greater emphasis on debt and long-term liabilities, and Chicago's overall liability profile is challenged. City officials also note that the economy in the city continues to grow, and its legal obligation to honor debts backed by its GO pledge remains strong.
Yet, we'd be remiss not to also note that the city continues to march toward its required spike in pension payments with little relief in sight. Annual pension payments will more than double in 2015, and now is the time to craft budgets to deal with this very challenging prospect. Legislative changes in 2010 achieved some pension reform by creating less generous benefit packages for new hires after Jan. 1, 2011, and mandating that, beginning in 2015, the city levy property taxes in an amount sufficient to bring both the police and fire retirement funds to a 90% funded ratio by 2040 (funded currently at 31% and 25%, respectively).
In fiscal 2012, total contributions for all four of the city's pension funds were $476.3 million (15.3% of corporate fund spending) and resulted in an aggregate unfunded accrued liability of $19.5 billion and an aggregate funded ratio of a very low 36%. Officials estimate that contributions from general revenue totaled $479.5 million in fiscal 2013 and the total unfunded liability remained well above $19 billion. Under the current state legislation that sets Chicago's pension payments, it's expected that the city's required contribution will jump to $1.1 billion in 2015, and the funds will still record a substantial unfunded liability of approximately $25 billion.
City and state officials continue to recognize that the current trend isn't sustainable, even with a stronger economy supporting higher costs, yet little has changed to alleviate the pressure. We recognize that overall credit quality is still good, the city has some financial reserves, the flexibility to raise revenue, a strong management team, and an improving economy. Yet debt is a rapidly growing concern, and investors should carefully follow developments regarding the city's pension plans and budgets in the near term.
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