December 15th, 2017
Well, it has been one heck of a year in muniland. If you had to summarize 2017 in just one word, that word would be “supply.” For the better part of the year, net negative supply conditions drove performance higher and credit spreads tighter, with some notable but localized exceptions, such as the Illinois credit cluster and the ever-worsening Puerto Rico debt crisis. Even tax reform, which has introduced more volatility into the muni market since the end of October, has had its greatest impact on the market by raising the spectre of a dramatic decrease in supply going forward.
2017 also saw the return of large, liquid high yield deals such as the American Dream issue in New Jersey and the Brightline Train issue in Florida. It also marks the return of the small, off-the-wall unrated deals that our friend Joe Mysak at Bloomberg loves to dish on: from a zoo on the Alabama Gulf Coast to an expansion project for Elvis’ Graceland in Memphis to a Proton cancer treatment center, we saw them all this year. In fact, one might say that it was The Year of High Yield Muni, as investors’ rising distrust of traditional GO structures and preference for revenue bonds, combined with a stable economic environment, helped traditional high yield sectors, such as tobacco and senior living, outperform the rest of the market.
For this issue, our last for 2017, we thought we’d review what we consider to be the major credit developments in the municipal market over the past year. We’ll save our 2018 prognostications for January, with the hope of being able to incorporate the final details of the tax reform package into our analysis. So, without further ado:
10. Cybersecurity becomes a real credit threat, particularly for health care issuers
According to a 12/13/17 report from HealthITSecurity, 78% of healthcare providers participating in a survey by HIMSSS Analytics, reported a ransomware or malware attack in the past 12 months. As our own Shelley Michelson wrote in a 3/27/17 report, “data breaches are costly to hospitals and physicians in both dollars and the damage to their reputations in the marketplace and can cause utilization declines, as patients switch to competing facilities or clinicians for care (…).” “Cybersecurity threats have worked their way into credit assessments with Moody’s warning in its report, Cyber Risk of Growing Importance to Credit Analysis, that unprepared and under-prepared hospitals could see lower credit ratings.”
9. The healthcare sector dodges a bullet early in the year but may get hurt again through the latest tax reform package
The healthcare sector started out the year on the defensive, with the new GOP-dominated Congress dead set to repeal Obamacare. After several abortive tries, it did not appear that such an effort was going to be successful this year. Everything was looking rather copacetic until the Senate released its version of tax reform a couple weeks ago which, lo and behold, included what amounts to a repeal of the ACA individual mandate. While this provision may or may not make the final cut, it’s fair to say that the pressure is back on stand-alone providers, particularly rural hospitals and safety net providers with a significant uncompensated care burden.
8. Nuclear construction risk returns to the municipal market
Thirty four years after the Washington Public Power Supply System (“WPPSS”) default, nuclear construction risk is rearing its ugly head again. Back in early 2012, the Nuclear Regulatory Commission’s approval of the construction licenses for the Vogtle Units 3 and 4 and Summer Units 2 and 3 was hailed as the beginning of a U.S. nuclear power renaissance, as it marked the first new nuclear plant construction projects since the Three Mile Island incident in 1979. However, it didn’t take long before the old scenario of construction delays and cost overruns took hold again, this time with a new twist: the untimely bankruptcy of the project contractor, Westinghouse, a unit of Toshiba Corp, in March of this year. It also didn’t take long before the public opinion backlash started to create all kinds of political risk for the municipal utilities involved in these projects, from Santee Cooper in South Carolina to MEAG in Georgia, putting their ability to complete the projects and recover sunk costs in jeopardy. Can you say “Whoops” all over again?
7. Tight market technicals continue to drive a deteriorating trend in security packages
Is it 2006 all over again? One of the by-products of a strong technical backdrop is that issuers are once again in the driver’s seat when it comes to what type of security package they’re willing to pledge. For large, established healthcare names, that means kissing goodbye to the notion of funding a debt service reserve fund. The low point for this trend, in our opinion, came with the American Dream issue, which actually removes the bondholders’ right to declare an event of default (we’re talking about an actual monetary default, not just a technical default). Even the recent Sales Tax Securitization Corp. issue (“Chi-fina” among friends) had no debt acceleration clause in the event of default! Will 2017 be known as a bad vintage year for muni deals, similar to the 2006-2007 period?
6. Climate Change is becoming increasingly recognized as an important credit factor
In years past, the tax-exempt market has been able to shrug off the impact of the hurricane season on Gulf Coast and Florida credits as transient events, largely covered by insurance, without lasting fundamental credit impact. Not so this year, as the severity and frequency of a Harvey, an Irma or a Maria have led municipal analysts to question whether coastal communities are adequately prepared for extreme weather events, should these events become the norm rather than the exception going forward. Triet, do you want to mention the wildfires in California?
Whether or not hurricane frequency and global warming are related is still a matter of considerable scientific debate, however, it’s fair to say that there is growing recognition, particularly on the part of rating agencies, that climate change should be incorporated into our fundamental credit research framework.
5. The Puerto Rico debt crisis plumbs new depths in the wake of Hurricane Maria
A year ago, it would’ve been hard to imagine how things could ever get worse for Puerto Rico. But Hurricane Maria and its tragic humanitarian aftermath did take the island’s economic and fiscal crisis to a whole new, lower level. The bellwether GO 8.00% of 2035 has traded down to a new record low of about 22 cents on the dollar, losing about 62% of its value from before the hurricane hit. If the interplay between the Control Board, the Rossello Administration, and bankruptcy judge, Laura Swain, wasn’t complicated enough, we now have to contend with an additional player in the Federal government, through its disaster relief package. Puerto Rico disaster relief has now become a political football at the national level, with politicians and celebrities crossing the line with their argument for total debt forgiveness.
That’s not all, unfortunately. The current tax reform proposals from both houses of Congress, unless modified, may also undermine Puerto Rico’s tax haven status.
4. The “Public Pension Apocalypse” catches the public imagination
This was the year when every financial market pundit, whether well-versed in municipal finance or not, felt compelled to call for a “public pension apocalypse,, a systemic event with the potential of bringing down the entire asset class. In case you missed it, this is how we responded in our October 20th column: “Just to be clear, we’re not expecting the kind of systemic crisis that many so-called “muni tourists,”self-appointed experts with little appreciation for the workings of public finance, are calling for. These new students of the Meredith Whitney School of Over-Reaching Analysis tend to forget that state and local governments are perpetual entities with much more flexibility to restructure their long-term liabilities than the average corporation, as long as the political will is there. It may be a messy, lengthy, contentious political process, but in most cases, solutions will be found. We certainly do believe in the seriousness of the pension crisis, but in a pension apocalypse? Hardly.
3. The “Illinois Credit Cluster” makes a comeback from the edge of the abyss
The “Trade of the Year” title clearly belongs to what we call the “Illinois credit cluster,” which includes the State GOs and State-dependent credits, but also the City of Chicago and its Public School System. Even though Chicago and its Public School District certainly had their own fiscal issues, their fate was also, to a large extent, tied to the State’s budget deadlock.
Going into this past summer, the entire credit cluster had been hammered by investors concerned about the lack of a State budget for more than two fiscal years. It took the threat of a downgrade to “junk”, i.e., below investment grade, by the rating agencies to motivate the State Legislature to come up with a bi-partisan budget agreement, including a bi-partisan override of Governor Rauner’s veto, just days after the Fourth of July holiday. Illinois and Chicago-related credits have been on a tear since the budget breakthrough, making the so-called High Yield GO sector the best performer in the second half of the year.
2. Securitization/Revenue Carve-Outs become the new lifeline for distressed issuers:
2017 saw the convergence of three related credit trends in the municipal market: (a) the growing discomfort on the part of muni investors toward the traditional Full Faith and Credit General Obligation (“GO”) pledge in the wake of the Detroit bankruptcy; (b) the resulting move toward revenue bonds or revenue bond-like structures; and (c) the growing recognition of the value of a perfected security interest and/or statutory lien on pledged revenues. Not surprisingly, the Unholy Trinity of bond counsel, investment bankers, and rating agencies came up with the perfect solution for distressed issuers to regain market access and reduce their interest costs: securitize and transfer an existing revenue source into a bankruptcy-remote entity in order to earn a much higher rating. Indeed, this gimmick worked to perfection for the City of Chicago this year, albeit with a little help of a supply-panicked market.
Next up at the securitization altar? The State of Connecticut, with plans to securitize some of its income tax revenues.
1. Tax reform will have an impact on state and local government credits, quite apart from its effect on market supply.
At this writing, although few details have been released, it appears that the conference committee version will preserve the tax-exempt status of private activity bonds, albeit with some new restrictions, and that advance refundings are indeed a thing of the past, all as we predicted in our last issue.
Looking ahead to 2018, we suspect that the credit theme will be “The New Federalism,”as market participants will come to realize that the relationship between Federal, State, and local governments will be significantly altered by tax reform. Unfortunately, that will probably translate to more fiscal pressure at the state and local levels, to be discussed in greater details in our January 2018 newsletter.