Week of 2/21/2022

Why Puerto Rico Bonds Could Outperform… Credit Positive: Puerto Rico Retail Surge… State Revenues Could Abate… Illinois on Fitch Upgrade Track… Faster Pace of Rate Hikes…

Why Puerto Rico Bonds Could Outperform… An end to the biggest bankruptcy ever in the municipal bond market will leave Puerto Rico with a significantly lower debt load. Puerto Rico’s oversight board seeks to execute the bond exchange and cash distribution to bondholders by March 15. After that, Puerto Rico will pay no more than $1.15 billion in principal and interest annually on its general obligation bonds and sales-tax debt, down from as much as $3.9 billion. Last week, Puerto Rico House of Representatives approved money from past years’ Island revenue for cash distributions to the Island’s bondholders per the court-approved debt plan. Although the measure failed to get Senate approval, the board has maintained it can make the changes to spending without local government approval “The legislature is just doing political positioning,” an Island-based bondholder group explained. Oversight Board spokesman said that the board would approve the spending on Friday. The debt plan was approved by the Title III court in January 2022 amid a resurgent economy. The Island’s tax collections and cash balances have grown amid its economic revival fueled by massive federal aid for pandemic relief and post-hurricane rebuilding. A lower debt load brings more fuel for the Island’s economy. After the bankruptcy exit, every dollar of taxes and fees that the Commonwealth of Puerto Rico collects, just 7.2 cents will go to creditors, leaving the remaining revenue for Island spending. That is good news for economically sensitive contingent-value securities that bondholders will receive along with fixed coupon bonds and cash. With an imminent $7 billion cash distribution, bondholders are likely to seek higher yielding tax-free bonds, a boost for high yield municipal bond sector that has seen outflows in recent weeks. As the Island strides closer to exiting bankruptcy, Puerto Rico bond prices have rallied. Puerto Rico general obligation bonds traded at close to 90 cents on the dollar, up from 87 cents in January, defying broad price drops elsewhere in the bond markets. Prices on the newly restructured Puerto Rico general obligation bonds are expected to increase following the debt exchange, echoing the trend set by COFINA bond prices after the 2019 restructuring.

Credit Positive: Puerto Rico Retail Surge… November 2021 brought the ‘strongest growth’ in monthly retail sales, in a decade. The trend is expected to continue in 2022. November retail sales were $3 billion or 18% higher than a year ago. For the eleven months ended November 2021, retail sales are 23% higher compared to a year ago. The Island’s retail sales have jumped from strength to strength for eighteen consecutive months. The biggest surge came from food, fuel, clothing and auto parts. “This need to return to normality, together with the massive vaccination campaign, were key elements to promote greater economic activity during that period. We trust that pattern will continue to repeat itself throughout 2022,” noted Puerto Rico’s Department of Economic Development and Commerce Secretary. To take advantage of favorable conditions, Puerto Rico’s fiscal agency is exploring the potential for achieving debt service savings on COFINA Bonds, which are trading at premium prices. A COFINA bond backed by sales tax revenue and maturing in 2058 traded at an average price of 109 cents on the dollar recently, up from 97.4 cents at issuance in February 2019 when COFINA exited Title III bankruptcy.

State Revenues Could Abate… Torrid growth in state tax revenue in fiscal 2021 will wane in coming years. First, federal pandemic aid, which increased personal income by $2 trillion-plus from spring of 2020 to fall 2021, came to an end in September 2021, the first quarter of Fiscal 22 (which started on July 1, 2021). Eighteen months of stimulus checks, expanded unemployment insurance and other federal support propped up consumption spending and tax revenues. Second, states’ capital gains tax collections are likely to be lower in Fiscal 22 and Fiscal 23 amid rate hikes and volatile asset valuations. Record high capital gains, realized in 2020, boosted state coffers as asset values soared fueled by ultra low interest rates during the pandemic. A lower ‘wealth affect’ ripples into lower consumption. Third, the pandemic’s car buying frenzy will likely fade away, dampening sales tax receipts. Fourth, additional waves of federal aid, such as the enacted Infrastructure Investment and Jobs Act, could boost state tax revenue, but the spending will occur over several years. Finally, inflation has potentially opposing effects on state tax revenue: price increases on taxable goods and rising wages lift revenue, but can also reduce household consumption. Future payrolls and capital gains will determine the path of personal income tax collections. Income tax dependent states, and those with progressive income tax rates, will be most vulnerable to slower revenue growth. Outmigration from high tax states will impact sales tax collections. Nationwide, state tax collections will grow slower in Fiscal 22 and Fiscal 23.

Illinois on Fitch Upgrade Track… Upward rating potential for the State of Illinois is in the mind of Fitch. “Continued operating performance improvement and structural balance could support a return to the state’s pre- pandemic rating or higher,” Fitch added that continuation of on-time budgets that primarily address fiscal challenges with sustainable measures could support positive rating action. The onset of the pandemic led Fitch to cut Illinois’ rating to ‘BBB-’. All three ratings agencies have offered positive reviews of Governor Pritzker’s executive budget. Credit positive for Illinois, the governor recommends largely nonrecurring uses for the significant revenue surplus to build fiscal resilience. To mitigate credit risk, tax relief is structured as one-time, as state source revenue growth fades to 1% in Fiscal 2023, about half the projected growth rate in Fiscal 22. Illinois legislature’s review of the budget is likely to conclude in early April. “Fitch recognizes the significant progress made by the state the past three years and I appreciate the thorough review contained in the report,” Illinois budget director stated “Illinois has made major strides towards returning to pre-budget impasse strength, and, in many ways, is returning to a fiscal position not seen in over a decade.”

Faster Pace of Rate Hikes… Investors have begun to bet on the Fed reversing its tightening course late next year. Based on December 2023 and December 2025 euro dollar future contracts, markets are betting on a reduction in the fed funds rate, but a 25-basis point reduction isn’t priced in yet. With increasing hostility between Russia and Ukraine, traders dialed expectations for a rate hikes, with 78% odds for a 25-basis point rate hike in March. A week back, odds were near even between a 50 basis point and 25 basis point March rate hike. A Reuters poll of 84 economists taken Feb 7-15 showed a majority expect a 25 basis point rate hike in March, and rates could rise each quarter this year to reach 1.25-1.50% by end-December, roughly where they were at the start of the pandemic two years ago. One-quarter of respondents, 21 of 84, saw rates even higher by end-2022. Minutes of the Jan 25-26 Federal Open Market Committee noted “Most participants noted that, if inflation does not move down as they expect, it would be appropriate for the committee to remove policy accommodation at a faster pace than they currently anticipate.” A record $30 trillion in federal debt will keep aggressive rate hikes in check. Federal interest payments could jump by $600 billion a year, if rates top out at 2%, and impact future spending. An aggressive tightening cycle could be the recipe for an economic downturn in 2023 or 2024.

Compare 30-Year taxable U.S. Treasury yield 2.25% to 30-Year tax-exempt muni bond yield “AAA” 2.10%; “AA” 2.30%; “A” 2.71%; “BBB” 3.07%. For investors in the 35% tax-bracket, a 3% tax-exempt yield is equivalent to a 4.6% taxable yield. Top rated tax-free bonds yield 93% of comparable taxable U.S. Treasuries.