Updated: Jun 19, 2018
February 16th, 2018
A few weeks ago, I had the opportunity to moderate a panel at the National Federation of Municipal Analysts’ Advanced High Yield Seminar. The panel’s title was “Security Package Degradation: Is It 2006 All Over Again?”, a topic that I personally think has not gotten enough attention from the financial media. I was fortunate to have the participation of three great experts on the subject: Jim Murphy, a senior portfolio manager and high yield muni team leader at T Rowe Price; Chris Tucker, a senior healthcare banker at PNC Capital Markets; and Bill Rhodes, a recognized legal expert at Ballard Spahr on high yield and distressed issues.
So, what do we mean by “security package degradation”? That term refers to the phenomenon whereby, at particular points in the credit cycle, the demand versus supply equation tips so much in favor of issuers that it allows said issuers to offer a much weaker security package to investors and get away with it. Where investors think we are in the economic/credit cycle and their general appetite for credit risk are also influential factors. It’s our muni version of the “Covenant Lite” periods that the corporate and secured loan markets go through every so often.
The following historical chart, courtesy of Jim Murphy, shows there has been three distinct “Covenant Lite” periods in the municipal market since 1994, occurring about 10 to 12 years apart: 1997-1999, 2006-2007 and 2014 to the present. Each of these periods were characterized by significant spread compression and strongly positive mutual fund flows. Of course, what used to be called “strong technicals” back in the 1990s now looks rather insignificant compared to the massive fund flows of recent years, which would explain why the current period of security package degradation is now going into its fourth year.
No wonder Jim’s response to the question: “Is it 2006 All over Again?” was an emphatic: ”No, it’s actually much worse than 2006”.
Graph Courtesy of T Rowe Price
The security covenant dilution trend has been most obvious in the sectors that, in normal times, tend to have the most standardized security package: healthcare and higher education. Those sectors also happen to include some major hospital systems and universities, well-recognized credits that can flex their muscle in the marketplace and force investors to forgo a debt service reserve fund or a mortgage pledge, among other things.
In his panel presentation, Jim Murphy presented a real life example of security dilution in the healthcare sector, for an entity he calls “Hospital A” (Jim has assured me it is a real hospital). It is quite an eye opener, as you can see in the chart below.
The most egregiously weak security packages can also be found in the high yield sector, hardly a shocking revelation to most market participants. As we’ve pointed out at length in past columns, we believe the Meadowlands American Dream from last summer marked a new low in investor protection. As we wrote in our June 2, 2017 column, “in an outrageous departure from standard security features, the documents for the PILOT Revenue Bonds state that non-payment of debt service will not be considered an event of default and the debt cannot be accelerated. Furthermore, as we understand it, a monetary default will result in an “automatic extension of the maturity of the bonds and (…) continued accrual of interest at the stated rate thereon until the earlier of (i) the date when such maturity is paid in full and (ii) June 1, 2057.”
Bill Rhodes from Ballard Spahr did point out that in distressed tax-backed issues, the current trend is actually going the opposite way, meaning that investors are demanding stronger security packages whenever they can. This is particularly true of weaker general market names such as City of Chicago or Chicago Public Schools, where a securitized, bankruptcy remote structure is now favored over the traditional G.O. pledge.
Speaking of securitization, this week’s marquee issue was undoubtedly the $1.5 billion tobacco settlement revenue deal for the Commonwealth of Pennsylvania, issued by the Commonwealth Financing Authority (“CFA”). The deal’s rather attractive pricing was fairly emblematic of the muni market’s current lack of conviction in the face of an increasingly bearish Treasury market.
In a nutshell, the CFA issue was secured by payments received by the state pursuant to the Tobacco Master Settlement Agreement (“MSA”) and by a package of so-called Article II revenues, consisting of a statewide 6% sales tax and 6% hotel tax. To guard against the State’s propensity not to pass its budget on time, all pledged revenues are subject to what is referred to as a “continuing appropriation, not subject to passage of the state budget”.
Not surprisingly, the deal was wildly oversubscribed and was upsized from its original $1.39 billion. Even after a 20 to 22 bps “bump” on the uninsured maturities (i.e. yields lowered by 20 to 22 bps), the final spread (around +120 bps off BVAL AAA for the 2035 maturity) remained very attractive for what is in effect a "double-barreled" security pledge, topped off with a cherry in the guise of an appropriation pledge from the Commonwealth.
As some of you may recall, past tobacco issues such as California's Golden State Tobacco Securitization Corp. also came in two different flavors, one as a pure securitization with only the tobacco revenue pledge and the other enhanced by an appropriation pledge from the state. The Pennsylvania issue probably should be viewed as a little better secured than the regular tobacco appropriation deal, in our opinion.
The most compelling relative value, in our opinion, was the insured term bonds in 2039, at roughly a +110 spread off BVAL Base AAA. The bond insurance wrap should go a long way toward assuaging the concerns of tobacco bond investors who have been reluctant to go out very long on the curve, given the higher probability of default in the back years.
Those looking to rationalize the relatively attractive pricing on these bonds can point to the legal cloud hanging over the deal: on January 23, 2018, Phantom Fireworks Showroom, LLC, filed a lawsuit challenging the constitutionality of the entirety of Act 43 which authorized the leveraging of a portion of the annual Master Settlement Agreement payments, while also imposing regulations, licensing requirements, and sales tax provisions on the sale of fireworks. The Company’s objection, however, is to the specific portion of the Act that deals with fireworks taxes, which represents a fairly minor portion of all Act 43 revenues.
Ultimately, the Commonwealth was able to market the deal by stickering the Preliminary Official Statement with an opinion from special counsel Greenberg Traurig, LLC, to the effect that the bonds are validly authorized and issued and no person can question their validity, sale or execution and “the finding of unconstitutionality of Act 43, which authorizes the issuance of the Bonds”(…) Greenberg’s opinion, however, was so full of caveats that one could scarcely call it an “opinion”. Even Greenberg has to admit it is “not a guaranty of what a court would hold, rather it is an informed judgment as to a specific question of law”!
The market may also be wise to the fact that this tobacco settlement is nothing more than deficit financing, that it will only provide a one-time budget deficit plug while forcing the state to come up with other recurring revenue sources to replace the securitized MSA receipts going forward.
Then again, perhaps the tobacco industry connection also cost the Commonwealth a few basis points in a tax-exempt market newly enamored of anything deemed ESG-compliant? But, are tobacco bonds really not ESG-compliant? Buying tobacco settlement bonds is clearly very different from buying bonds issued by tobacco companies. After all, the pledged revenues come from the MSA, which was designed, at least initially, to penalize the tobacco companies, discourage cigarette consumption and generate revenues that would go toward funding health care or tobacco prevention programs. Surely that does accomplish a social purpose?