Week of 6/17/2019

Bond Market Rejects Puerto Rico GO Debt Restructuring Framework…Judge Swain Questions PREPA Debt Deal…Chicago Mayor Mulls New Taxes Amid ‘Credit Positive’ Illinois Budget…U.S. States’ Finances Improved…Golden State Budget Brings Resilience…Opinions on Rates… Inflation Ebbs Lower…Attractive Prices Of Long Term Munis…

Bond Market Rejects Puerto Rico General Obligation Debt Restructuring Framework…The bond market expects a higher recovery on Commonwealth full-faith-and-credit bonds than suggested by a tentative agreement between the oversight board and a select group of hedge funds. Opposed to the low ball recovery and unequal treatment of bondholders, Assured Guaranty stated that the plan violates Puerto Rico and federal law. Puerto Rico’s economic upswing causes bondholders to expect more than the proposed recovery offer of 64% for vintage general obligation (GO) bonds, 45% for Series 2012 GO bonds, 35% for Series 2014 GO bonds, 73% for vintage Public Building Authority bonds (PBA), 23% for Series 2012 PBA bonds. Per the proposal, the Commonwealth’s debt service would be cut by about half, to $21 billion from $43 billion; creditors would receive $12 billion in restructured debt and $2 billion in cash. “An unprecedented and meritless attempt to invalidate certain lawfully issued general obligation bonds, acceptance of erroneous and misleading financial projections in the Oversight Board’s legally flawed fiscal plan, and artificial separation of similarly situated creditors into classes that would receive unequal treatment,” Assured Guaranty balked at the agreement between “barely 10% of Commonwealth guaranteed and GO creditors, who bought positions at prices substantially below par, failed to include the largest general obligation creditors who have supported Puerto Rico for decades.” At odds with the tentative recovery, GO and PBA bonds continued trading higher than the proposed recovery. Series 2012 GO bonds trade around 55 cents or ten cents higher than the proposed recovery. Series 2014 bonds traded at 49 cents or 15 cents higher than the proposal; and other Commonwealth full-faith-and-credit bonds followed a similar pattern. Bondholders’ rejection of the low ball offer is premised on many factors. Not only has Puerto Rico’s economy turned a corner, more clarity on the finances and tactics of the Island administration has emerged during the two-year bankruptcy proceeding and prior debt settlements. Bondholders have reasons to expect more from Puerto Rico. Any proposal must garner the requisite votes and Assured Guaranty’s participation is almost a prerequisite for the Island’s future access to capital. At best, the proposal sets a floor for ongoing negotiations with major bond insurers. The bond market is unfazed by the tentative framework.

Judge Swain Questions PREPA Debt Deal…Federal Judge Swain raised doubts about fairness, reasonableness, and adequacy of the debt agreement reached between Puerto Rico’s electric utility and some creditors to restructure the utility’s $8.5 billion debt. Judge Swain needs Puerto Rico’s government to establish the benchmark range of reasonableness for consensual recovery on the bondholders claim to determine whether the discount to the claims as a result of the settlement in the RSA falls within the range of reasonableness. Just having a consensus between opposing parties is not enough and Puerto Rico’s government must provide additional facts and legalities as well as needed legislation for the relief sought instead of ‘conclusory assertions’. “I think that the scope and complexity of the deal demands significantly more to demonstrate that the deal reached by the parties is fair and equitable.” Similar questions were earlier posed by Junior COFINA bondholders, majority retail held, in their opposition to the COFINA Plan of Adjustment to Judge Swain herself. It is intriguing as to why Puerto Rico’s conclusion that the COFINA Plan was ‘fair and equitable’, ‘reasonable’ and ‘adequate’ was not questioned by Judge Swain despite many requests from retail bondholders, although notable that Judge Swain is now asking those difficult questions to the Island’s government.

Chicago Mayor Mulls New Taxes Amid ‘Credit Positive’ State Budget…“There’s no question we’re going to have to come to the taxpayers and ask for additional revenue,” Mayor Lightfoot is expected to come up with a combined $528 million in tax increases and budget cuts for the Windy City. New taxes could come in any form, be it higher fees or property tax hikes. Chicago Public Schools stand to gain from a $375 million boost in state aid to schools provided by Illinois’ fiscal 2020 budget which comes on the heels of $350 million higher state aid in fiscal 2019 and 2018. A flurry of recent legislation and Illinois 2020 budget are credit positive for local governments because they will receive new funding from doubling the statewide motor fuel tax and from additional sources of operating revenue. New revenue from legalized recreational marijuana is less certain and new casinos have the potential to generate significant revenue that could be meaningful for closing pension gaps. Moodys has termed the Illinois budget ‘credit positive’ for the state’s local governments. By 2023, Lightfoot will need to come up with nearly $1 billion in additional annual pension payments. Moreover, Chicago needs to get “a handle on these settlements, judgments and attorneys’ fees,” the mayor referred to the high cost of lawsuits against the Windy City. “We have a lot of hard choices we’re going to have to make regarding city finances,” Chicago’s mayor is expected to piece a bevy of new revenues and settlements in her inaugural budget expected in the fall.

U.S. States’ Finances Improved…Most U.S. states are meeting or exceeding their revenue projections for the current year. None of the 50 U.S. states had to make mid-year budget reductions in the current fiscal year amid strong revenue. 21 states have proposed tax and fee hikes and the largest source of new revenue is from motor fuel tax hikes proposed in five states, NASBO reported. States’ rainy day funds, expected to reach a record high at 8.6% of overall expenses. Rainy day funds were only half as much when the Great Recession began and dwindled after state revenues dropped an average 11% in 2009-2010. An improved fiscal environment has led U.S. states to be better prepared for a recession than at any other time in recent history.

Golden State Budget Brings Resilience…Governor Gavin Newsom’s inaugural budget shores up rainy day funds and pays down debt taking a leaf from former Governor Jerry Brown’s agenda that led the Golden State to pay down its ‘wall of debt’. ‘Building budget resiliency’ is Newsom’s mandate as California’s $215 billion fiscal 20 budget carries $20 billion in reserve funds. Some of the surplus is to make extra pension payments to help cover unfunded pensions for teachers and state employees and to help school districts cover pension contributions. The lion’s share of the budget goes to public schools, and healthcare has been prioritized. Democrats favored the budget, passed by the state Assembly and Senate, and it is expected to be signed by Governor Newsom (D) although a few trailer bills are pending. “What a luxury we have, to get to stand here and argue over where we should put our savings, how we should spend some of the additional money we have to support struggling Californians,” a lawmakers’ comment reminds bondholders of California’s small surplus in 2013, post the Great Recession that left budget shortfalls. Since then, the Golden State’s finances have come a long way and the journey has been rewarding to bondholders.

Opinions on Rates…Noted bond investor Jeffrey Gundlach believes there is a 40% to 45% chance of a U.S. recession in the next six months and a 65% chance of one in the next year. Gundlach said it was ‘extremely probable’ the Federal Reserve would have to cut interest three or four times in the coming months. A cut by September is ‘almost a lock’. He added it was possible one of the rate cuts could be 50 basis points. Futures markets see an 80% chance of 0.25% rate cut in July, followed by near-certain similar cuts in September and December.

Inflation Ebbs Lower…Across the board, price gains fell short of expectations in May. Core prices rose by 0.1% in May lower than prior months’ 0.3% price gain. Consumer price gains in May, 1.8% from a year ago, have eluded the Fed’s 2% target and muted prices mirrored in producer price gains that show wholesale level prices. Import prices fell 0.3% from a month ago and are 1.5% lower than last year. Export prices too declined by 0.2% in May and are 0.7% lower than a year ago. “We’re really never going to get inflation,” a TD Securities strategist stated. Although the U.S. economy is growing at roughly its long-term trend, it is a downshift from last years’ growth. Deflationary pressures include a strong dollar, lower energy prices, and wage pressures amid higher tariffs. The Fed Reserve will walk a fine line as it weighs mute inflation, upbeat retail sales, and less than expected jobs growth when it meets this week.

Attractive Prices of Long Term Munis…Tax-free top-rated muni yield 2.42% or 93% of comparable taxable U.S. Treasury yield 2.6% for 30 years. The $3.8 trillion tax-free bond market is shrinking. Governments have paid off bonds, owing $143 billion less than they did nine years ago. Lower debt is credit positive for state governments awash with soaring tax collections. For investors, this means lower supply of municipal bonds. This week $6.2 billion of new municipal bonds will be issued down from last week’s $9.9 billion. Meanwhile, more investors sought munis marking 23 straight weeks of inflows to munis.

Compare 30-Year taxable U.S. Treasury yield 2.60% to 30-Year tax-exempt muni bond yield “AAA” 2.42%; “AA” 2.65%; “A” 2.82%; “BBB” 3.36%.