Week of 3/14/2022

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Higher Inflation Outlook…How Will Inflation Impact Muni Issuers…Judge Swain Orders PREPA Debt Mediation….Appeals Court Upholds Puerto Rico GO Debt Plan… Detroit Earns Rating Upgrade… Is It Time For Opportunistic Municipal Bond Buyers?…

Higher Inflation Outlook… Surge in oil prices, a fallout of the Russia-Ukraine war, has the potential to exacerbate inflation. Inflation could surge as high as 10% year-over-year if oil prices rocket to $160 for a barrel, and could be close to 9% in March if oil prices stabilize at current levels ($120 per barrel) economists predict. Driven by higher fuel and food costs, February 2022, consumer prices jumped 7.9% higher than a year ago, and are 0.8% more than prior month. Americans are paying an extra $1 per gallon at the pump due to the Russia-Ukraine war. The Russia-Ukraine war could worsen inflation. Price gains of commodities such as wheat, corn, soybeans, industrial metals and semiconductor manufacturing components, supplied from the war-torn region, feed into the inflation outlook. The jump in commodity costs will mean inflation will not likely decelerate for months, former Treasury Secretary Lawrence Summers warned. Even before the war, the reopening of the economy brought higher gas prices and supply constraints on auto parts and computer chips. Gas prices are set to rise further, and inflation could peak in March or April. Before the war, 10% of U.S. oil came from Russia. Increased U.S. shale production, likely to bear fruit by year-end, could curb oil prices. Potential for oil prices to remain higher for longer could compel the Fed to raise rates more aggressively.

How Will Inflation Impact Muni Credits… Governments’ service delivery costs are set to climb 10%, the highest surge since the early 1980s. Inflation is likely to boost government revenue from income tax, sales tax and motor fuel tax, that carry material inflation protection. Many government services have an inelastic consumer demand. Inflation could be an obstacle for regions and government agencies that depend on discretionary spending such as travel and tourism. Motor fuel taxes, linked to gas prices, are part of a raging political debate. New York and California seek to abate state gas tax, while New Jersey and Michigan prefer a federal gas tax holiday. In New York State, local government sales tax collections in 2021 outpaced pre-COVID (2019) levels by 7%, the state comptroller attributes some of the rapid sales tax revenue growth to inflation and higher gas prices. However, inflation will filter into governments’ procurement, maintenance and construction costs, as well as cost of living adjustments built into public pensions and salaries. Utilities that follow an autonomous rate-setting policy to cover higher variable cost of fuel could be more resilient to inflationary pressures. Political resistance could challenge government enterprises requiring public approval for rate hikes. With the CPI at historically high levels and most toll roads continuing to adjust their toll rates accordingly, near-term toll revenue growth should accelerate. Labor shortages are weighing on margins for education and healthcare sectors. States and local governments entered the current inflationary period with strong finances boosted by federal aid and stellar pension returns. “Combined with our expectation for inflation to decline later this year, we expect most governments and other public finance issuers will navigate expense increases in 2022 without a material erosion of their credit quality,” Moody’s stated. States’ upward revenue trajectory that began in Fiscal 21, is set to continue in Fiscal 22. Forty-two U.S. states are likely to exceed or meet forecasted revenues in Fiscal 2022 per a recent National Conference of State Legislatures survey. In the near term, the effect of inflation on municipal credit will be relatively muted, while persistent inflation could be an economy-wide challenge.

Judge Swain Orders PREPA Debt Mediation… “The court expects and recognizes the need for prompt and effective engagement in any actions necessary to bring PREPA’s Title III case to a speedy, appropriate conclusion that is consistent with the law and that can provide for a better future for Puerto Rico,” ordered Judge Swain after Governor Pierluisi notified on March 8, 2022 that Puerto Rico has terminated the 2019 debt pact known as the RSA. Changed circumstances, including rising inflation and higher oil prices, are cited as reasons for the Island seeking a ‘comprehensive negotiation and mediation to resolve outstanding PREPA debt. The oversight board supports the termination of the 2019 RSA which was rejected by the island legislature. The 2019 RSA had the support of 90% of bondholders. Separately, Puerto Rico is asking the oversight board to authorize the use of at least $200 million in emergency funds to subsidize power generation amid a spike in international fuel prices. By May 8, 2022, the oversight board will likely file either a new restructuring plan, or a term sheet of a proposal, or a schedule for litigating disputes, or reasons explaining why the Title III court should not dismiss the 2019 RSA. Judge Swain urged, “The timely proposal and subsequent confirmation of a Prepa Title III plan of adjustment is paramount to the commonwealth’s economic recovery and expeditious exit from these Title III bankruptcy proceedings.” Puerto Rico’s oversight board, Pierluisi officials and the ad hoc group of investors holding about half of the utility’s outstanding bonds, and major stakeholders will discuss a new plan.

Appeals Court Upholds Puerto Rico General Obligation Debt Plan… The U.S. Court of Appeals struck down teachers’ effort to upend the central government debt plan. The Puerto Rico general obligation bond exchange is set to proceed as contemplated by the court approved debt plan.

Detroit Earns Rating Upgrade… Detroit’s’ Moody’s credit rating moved a step higher to ‘Ba2’, two notches away from investment grade territory. Moody’s first credit upgrade since 2018 comes after eight consecutive balanced budget plans. S&P’s last upgrade of Motor City dates back to 2019. Detroit posted its sixth consecutive operating surplus in fiscal 2021 and is on pace for another strong year in fiscal 2022. Motor City, an industrial and logistics hub, exited bankruptcy protection in 2014, and must present balanced budgets that look ahead four year to obtain an annual waiver from direct state oversight. Poised to further strengthening its finances over the next two years, Detroit will face rising pension costs in fiscal 2024. “The positive outlook reflects the likelihood that the rating will move upward if financial operations and reserves continue to strengthen, positioning the city well to address growing pension costs and future revenue downturns,” Moody’s reflected optimism for favorable rating actions.

Is It Time For Opportunistic Muni Bond Buys?… Municipal yields rose up to seven basis points Thursday pushing the one-year triple-A muni to 1%, a level not seen since April 2020 during the initial COVID-led selloff. Municipal bond funds are experiencing outflows. Municipal bond sales are down 8% from a year ago. Thursday marked the 19th day this year where the amount of bids-wanted reached at least $1 billion, a reversal from 2021 when that happened only twice. Citigroup analysts said that the municipal bond market is “past the point of peak pain” and suggest this may be a time to buy. “This is a good, opportunistic time for people to engage in the market and be able to pick up yield, something we haven’t seen since March 2020,” a municipal portfolio manager stated. However, others including Vanguard counter stating that assessing value is more difficult with Treasury yields being a moving target. “This year, investors are faced with some of the hardest market conditions in recent history, as muni-Treasury ratios keep oscillating, and rate volatility is never conducive to risk-taking,” Barclays strategists noted “The belly of the curve has adjusted enough that it is starting to get interesting versus Treasuries.”

Compare 30-Year taxable U.S. Treasury yield 2.42% to 30-Year tax-exempt muni bond yield “AAA” 2.27%; “AA” 2.60%; “A” 2.88%; “BBB” 3.28%. For investors in the 35% tax-bracket, a 3.28% tax-exempt yield is equivalent to a 5% taxable yield. Top rated tax-free bonds yield      94% of comparable taxable U.S. Treasuries