An Eventful Quarter For Municipal Credit

Triet Nguyen

April 8, 2019

"Never let a good tax scare go to waste", as we like to say in muniland.

The latest tax scare turned out to be the $10,000 cap on State and Local Tax Deductions, commonly known as SALT, which has sent high net worth investors in high tax states stampeding once again into municipal bond funds. Whether or not this was due to perception and savvy marketing rather than reality, as a recent Bloomberg article pointed out, the record inflows have triggered yet another winning quarter for the municipal bond asset class, sending muni-to-Treasury ratios to near record low levels. Lost in all the hype, however, were several potentially significant developments that may have a lasting impact on the tax-exempt sector's credit outlook going forward.

But first, let's review the market's performance, as reflected in the S&P Municipal Bond Indices.

The high yield municipal sector regained its market leadership this year, despite a brief swoon in 2018Q4 which has turned out to be only temporary, at least for the time being. The S&P Municipal Bond High Yield Index returned 3.80% this past quarter, outperforming the S&P Municipal Bond Investment Grade Index by 110 Bps. The one year performance gap was even more significant: +7.83% for High Yield versus +4.96% for Investment Grade.

Not surprisingly, the top performing sectors for the quarter included most of the traditional "high yield" sectors: Tobacco (+3.92%), Land-Backed (+3.58%) and Lifecare (+3.49%) were the top three sectors. Curiously, Nursing and Resource Recovery were the worst performing sectors for the quarter, at +1,63% and +2.27% respectively, but that may have been due to technical factors: there has been very little supply in those sectors, leading to lack of liquidity and lack of price discovery.

Proponents of ESG strategies, do take note: the Municipal Green Bond Index came in fourth in total return for the quarter (+3.41%) and fifth for the rolling 12 month period (+5.80%). If a socially impactful sector can be shown to produce competitive returns on a consistent basis, that would go a long way toward dispelling the average investor's lingering fear of leaving money on the table by "doing good", so to speak.

Among all states and US territories, the runaway winner in Q1 was Puerto Rico, with a total return of 6.16%, followed by South Carolina and Illinois at 3.14% and 3.08%, respectively. Regardless of how you feel about the legal outcome of the Cofina Title III case, you've hit the ball out of the park if you were lucky enough to go long any Puerto Rico bond at the end of 2017: Puerto Rico's one-year performance was a remarkable 20.37%.

The Virgin Islands showed up as the worst performer for the quarter, with a negative return of -2.08%, but that was just a modest give-back from its market-leading one year return of 32.40%. Interestingly, the S&P Municipal Bond American Samoa Index made its debut last month with a one-month return of 3.42%, driven primarily by the performance of the $50 million American Samoa Economic Development Authority General Revenue issue that came last fall.

With all the retail monies flowing into the municipal market this past quarter, it was easy to overlook the fact that there were a few very significant credit developments, not all of them positive for the market.

First, the high yield municipal market's rebound over the last few months may well turn out to be a technical head fake. Judging by the latest swoon in Treasury rates, the fixed-income market seems increasingly concerned that we're in the late innings of an amazingly long-lasting economic expansion and that the credit cycle is getting rather long in the tooth. The continuing volatility in trade policy may well be one of the potential catalysts for an economic setback. If such a scenario does enfold, credit spreads may blow out even as high grade yields remain low.

Since credit issues in high yield muniland tend to be micro-oriented and sector-specific, there is an entire crop of startup projects from circa 2006-2007 which are just now facing the stark reality check that comes with commercial operation. And many of these projects are of the scale seldom seen in years past: for example, one cannot think of a more economically sensitive project than the multi-billion American Dream retail mall at The Meadowlands, slated to open later this year.

And the deals are getting larger still. This past week saw the pricing of a $1.75 billion unrated private activity bond issue backed by Virgin Trains USA, formerly known as Brightline. This financing for a privately-owned passenger train service in Florida was certainly blessed with excellent market timing, garnishing a top coupon of 6.50% for the tranche with a 2029 put. Institutional buyers starved for yield piled into this issue, with the full knowledge that another $900 million follow-up deal is already in the works and that the bulk of the bonds will end up in the hands of only a few large players, thus ensuring limited secondary market liquidity. Who else but muni investors would accept a mere 6.50% return for a high risk, illiquid private equity type of venture?

The food fight for yield paper was in full public display a few weeks ago when Dallas-based Preston Hollow sued Nuveen for allegedly attempting to stifle competition for high yield direct placements. Needless to say, this sort of things used to be unheard of in the normally "genteel" tax-exempt market. One has to wonder if, to paraphrase my good friend Joe Mysak at Bloomberg, we'll look back at this period as "peak high yield muni" time!

This brings us to the Illinois credit cluster, which also had a rather interesting quarter. Although not formally recognized as "high yield" credits, even though they trade cheaper than some senior living issues, the Illinois/Chicago/Chicago Board of Ed trifecta continue to dominate the headlines.

The following chart gives you a feel for what has happened to credit spreads on the three major Illinois cluster credits over the past two years. Although the chart data only go out to February 15th, both the State of Illinois and the City of Chicago floated new GO issues last week. The Chicago issue marked Mayor Emmanuel and CFO Carole Brown's last foray into the market.

Chart: 20 Year Maturity Spreads vs MMA AAA for State of Illinois GO, City of Chicago GO & Chicago Board of Ed GO

Source: Refinitiv & Municipal Market Data

As we mentioned earlier, market technicals have been extremely powerful this quarter, so the timing for both the State and the City issues was quite favorable. Truth be told, both entities are in a state of political transition and are enjoying a honeymoon period of sorts with investors as well as with the rating agencies. 

At this writing, political newcomer Lori Lightfoot has just won a landslide victory in the City of Chicago's runoff election (it was actually a 3 to 1 blowout of Toni Preckwinkle) as the City's first black and openly gay mayor. This was, of course, a tremendous political and socio-cultural achievement, dampened only by the record low voter turnout of only about 32%.

During the runoff election campaign, both candidates went to great length to be evasive about their plans to address the Windy City's looming fiscal issues, although both talked down the $10 billion POB proposal advanced by the outgoing administration. While Toni Preckwinkle is better known to municipal market participants as Cook County's long standing head executive, neither candidate appeared particularly anxious to lock themselves into any kind of fiscal position before the election. It's fair to say, however, that neither candidate can be called an ardent "fiscal advocate". While it's never easy to put labels on politicians, based on Mayor-Elect Lightfoot's on-record comments to date, we would view her primarily as a "social advocate", whereas her opponent Toni Preckwinkle positioned herself more as an "education advocate", based on her close ties with the powerful Chicago Teachers Union. Obviously. the market will be watching to see what kind of financial team Mayor Lightfoot will surround herself with.

Another outcome of the Chicago election that bears watching: Lori Lightfoot is apparently in favor of turning the Chicago Board of Education (CBOE) from the current mayor-appointed to an elected board. Last week, the Illinois House overwhelmingly approved SB 2267 to establish a fully elected 20 member school board, its third such attempt in 3 years. This time, with the backing of both the Mayor-Elect and Governor Pritzker, this proposal has a better than average chance of becoming reality.

As can be seen in the chart above, after peaking in the summer of 2017, the spread difference between CBOE bonds and the City's GOs has narrowed dramatically by early 2018, but has since stabilized at about 70 bps. It's certainly hard to see the gap close further, given the prospect of a fully elected board which, we believe, will be less willing at the margin to make the necessary and difficult fiscal decisions (Of course, we're only looking at this narrowly from a creditor's viewpoint).

At the end of the day, current spreads (about +175 over MMD AAA for Chicago and +210 for the State, both in the 20 year maturity range) still reflect significant market concerns over the fiscal outlook for both entities, with Illinois still trading at what we would consider below investment grade level for a sovereign G.O. Although investors are giving the City more credit for improvements on the operating side achieved under the Rahm Administration, the balance sheet issues (debt/tax burden and pension funding) remain the overriding issues for both the State and the City. We suspect spreads will start drifting wider again unless both entities can show solid progress (or at least some kind of a plan) on pensions by yearend. City of Chicago taxable bondholders in particular will be technically attuned to the outlook for the $10 billion POB proposal, if it ever gets revived.

The first quarter also marked the completion of the Cofina bond restructuring, which, for better or worse, removed one of the major hurdles toward the ultimate resolution of the whole Puerto Rico debt crisis. It also removed one of the clouds hanging over the bond insurers, primarily Ambac in this case, which had the the largest relative exposure to the sales tax revenue bonds (a reported 78% of its aggregate exposure to the island's debt).

Ironically, despite the massive fees paid to advisors and consultants of all types on the island, the Cofina bond exchange process could only be called a disaster, particular with regard to its treatment of retail bondholders.

Despite such a messy start, it appears a healthy and active market for the restructured Cofina bonds has started to develop. And why not? The sales tax securitization structure was tested and not contested, at least for now. Given the complexity of the exchange process and related bond valuation, we suspect that the new Cofina bonds will become fertile grounds for active traders in search of attractive relative value.

Which gets us to the latest, and potentially most significant development in the municipal credit landscape over the past three months: on March 26th, the First Circuit US Court of Appeals upheld Judge Laura Swain's initial ruling on the Puerto Rico Highway Authority special revenue bonds. As you may recall, Judge Swain declared last year that special revenue bond payments are not mandatory in bankruptcy. To be clear, her opinion only undermined the special revenue bonds' traditional exemption from the stay in bankruptcy, not the investors' actual security interest in the pledged revenues. Nevertheless, this would have the effect of subjecting special revenue bonds to potential payment defaults and other vagaries of the bankruptcy proceedings. This latest legal setback, and potential solutions or workarounds for it, will undoubtedly be actively discussed by market participants in the weeks and months to come.

This serves as yet another reminder to us as municipal market participants not to start believing our own marketing pitch: the tax-exempt sector's much touted low historical default rate can be as much of a problem as it is a benefit. The relative dearth of Chapter 9 case law, combined with some ambiguities in the current statutes, leave us quite vulnerable to revisionist challenges of our current understanding of the bankruptcy process. Just look at what corporate bankruptcy lawyers did to us in the Detroit case: they turned a local government's capital structure on its head and forever undermined the full faith and credit General Obligation pledge. Ironically, the Detroit case has led muni investors to flock to dedicated revenue bond structures, only to be slapped down again by the latest First Circuit ruling.

All in all, it was quite an eventful first quarter. If this is the way 2019 starts, we can't wait to see what happens the rest of the year, particularly if the economic outlook starts to darken.