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ILLINOIS GO’s (Baa3/BBB-): JULY FIREWORKS AHEAD; JUNK SALE LIKELY

Illinois is in a serious bind. The road to perdition has been well lit, and signposted. 8 downgrades in 8 years for the General Obligation (GO) liabilities of the state, with another drop down to junk likely as soon as July 1st, the beginning of their 2018 “fiscal” year. Moody’s and S&P last moved June 1st taking the GO ratings to 1 notch above junk with the ominous warning that they will not be timid if further downgrades are in order. Illinois remains with a negative outlook and on negative watch with both major rating agencies. The unfunded pension liability of Illinois’ five state plans now exceeds US$130bln. IL State now has the lowest funded pension percentage (ranging from 37.5% to 44.2%) of all 50 states. All 5 plans have been achieving investment results well shy of their actuarial assumptions, the most prominent, State Employees’ Retirement System of Illinois (SERS) by -1.75%, returning 5.5% versus a 7.25% bogey (reduced modestly in 2013).

Each Illinois taxpayer is on the hook for almost $50,000 in unfunded liabilities (pensions and post retirement health benefits). Illinois is the 5th most populated state in the union at 12,800,000, for reference. Same ranking for income (for now). Illinois has proposed a 20% privilege tax on investment management services (read; hedge funds) which was tabled in February 2017, approved by the House Revenue and Finance Committee in March and if enacted becomes effective July 1, 2017. The taxation of carried interest is highly topical at both the Federal and State level presently with both NY and NJ considering similar legislation (CT and FL are gladly accepting hedge fund refugees at the time of publication).

In addition to the pension woes, Illinois has not passed a balanced budget for 3 years in a row, as required under their constitution. This has resulted in the untenable situation whereby the state has accumulated $14.5bln in “accounts payable”, on which they will owe $800mm in interest and fees as of June 30, 2017. The cascade effect (i.e. it rolls down hill) has been very damaging. Chicago Public Schools (CPS) are owed nearly 1/2 billion from the state ($467mm to be exact) and must resort to “Grant Anticipation Notes” to bridge the funding gap created. CPS are hoping to keep the cost below 8% which is the usury cap in effect for some school budgets. Chicago accounts for a full 20% of K-12 (Kindergarten through grade 12) enrollment but a more modest 15% of the IL state budget. Laughably, the Chicago teachers are not covered by the state Teachers Retirement System. Chicago Teachers Pension Fund (CTPF) is also a basket case, as you might surmise and in addition to a number of other issues led Illinois’s largest city to be downgraded to junk status in May 2015.

Bond investors have taken note. Spreads on Illinois debt to MMD (Municipal Market Data, the yield curve of the highest rated, AAA/Aaa  municipal bonds, as published by Thompson Reuters) have widened. The eventual downgrade to junk, aka non-investment grade, will make IL debt ineligible for investment for some of their major institutional investors (one of which has already called for a boycott of Illinois debt) which are restricted by mandate to purchase only investment grade muni bonds. There are of course high yield muni funds, but they tend to be smaller in terms of AUM and have had some performance hiccups (Puerto Rico) which have curtailed investor inflows. Suffice it to say there will be more sellers than buyers on a downgrade to junk status for Illinois.

Municipal investors are a conservative bunch. Not a lot of crypo-currency investors in this lot. They are typically older investors in the highest Federal tax brackets (39.6% & 35%), let’s call them the 3%. An increasing portion of muni bond portfolios are Separately Managed Accounts (SMA’s), but the majority are still via mutual funds and closed end funds. ETF’s have made some inroads, but modest in market share terms. 10 year Illinois debt is yielding approximately 4.3% (Federal tax exempt, State tax exempt for IL taxpayers and not subject to 3.8% Obamacare investment tax). Converting this to a TEB (Taxable Equivalent Basis) a non-IL resident in the top tax bracket would need to invest in a corporate bond yielding 7.6% to match. Note: HYG the $20bln high yield ETF yields 5.13% in comparison, hence you might need to buy an out of favor sector like bricks and mortar retail, otherwise non-rated is likely where you will find >7% in the US domestic bond market.

The same negatives that sent Puerto Rico (importantly not a State, technically a Protectorate https://ibankcoin.com/firehorsecaper/2016/04/10/puerto-rico-the-spoils-of-war/) on tilt recently are evident in Illinois as well, namely rampant crime and failing schools. Many schools are years behind in even tabulating scoring tests, which would be required to confirm their bottom quartile performance. To rival the record for shootings in Chi-town you have to go very far afield to places like Kabul.

Kentucky born Lincoln might hide the other half of his face if he were privy to the folly that has befallen “Land of Lincoln”.

Tread lightly, tread carefully. This is July business, post downgrade to junk for the GO credit. Remember, the highest yielding bond is often not the best “value”. Cross-over buyers that can not readily utilize the US Federal tax exemption (i.e.; foreigners, hedge funds) might look to the Build Illinois Sales Tax Revenue Bond which offers enhanced security (and ratings) from the dedicated sales tax pledge (This was also the thought with PR’s COFINA bonds which interest was recently suspended on by the courts, but you get the idea). The PO’s (Pension Obligation) bonds of Illinois are also taxable and will likely swoon a bit on a GO downgrade to junk status. Those looking to structured deals can vet Illinois tobacco settlement bond “Railsplitter” which was structurally superior on issue in 2012 as it could withstand smoking cessation rates of 4% wrt debt service (over $55bln of tobacco bonds have been issued across all 50 states).

Follow me on Twitter @firehorsecaper JCG

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US MUNICIPAL FINANCE – HIGH SCHOOL FOOTBALL STADIUM HUBRIS

If they ring a bell at the top of the muni bond market, this muni bond issue will be the poster child. Muni investors have long been considered the “C students” of Wall Street, but even for them, this may be too much.

McKinney ISD (Independent School District), Texas just voted yes to a new $220mm tax exempt bond issue which will help finance a $72,800,000 football stadium for their high school, yes their high school. Even though MISD is projected to grow by a scant 71 students (net) per year over the next 5, it has been determined that this all makes abundant sense. Most sane voters (Grassroots McKinney) would squash such financial folly, but the proponents of the deal, labelling themselves “Vote for McKinney’s Future” included the $50.3mm of “new” stadium earmarked money ($10mm was previously spent for the land and $12.5mm of debt was raised a full 16 years ago for the stadium) into a larger debt deal with sensical use of proceeds as a means push through this farcical stadium plan. The only way this could be more emblematic of the funk taking place in US of A is if it carried the name TRUMP stadium. A 10 year stadium naming rights deal could at least have resulted in some savings versus the ridiculous budget  for this open-air teenage concussion petri dish.

Stadium

Note: artist rendering of the new 12,000 seat McKinney high school football stadium.

This is far from an isolated case. Allen ISD is only a few miles away from the planned McKinney stadium, seats a much larger 18,000 and was built for $60mm (bargain). KATY ISD (near Houston) is in the final throws of approval for their very own $62.5mm cost, 12k capacity high school football stadium. The KATY ISD was established in 1898 and includes 60 school with a total annual budget of $785mm. KATY is ranked 13th place within Texas. One would think a top 10 academic placement might be a pre-requisite for spending $50mm+ on a stadium for a non-pro sport, played by teenagers, that may well be extinct or highly amended a decade out (watch the film Concussion, circa 2015).

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The US muni market is immense at $3.6 trillion and as with the Federal debt tally, much has been issued in the last couple of decades. In 1945 there was $20bln of muni debt, in 1960 there was $66bln, in 1981 there was $361bln and now we sit at $3.6 trillion.

Texas is a AAA/Aaa rated state. KATY ISD is rated Aa1/AA stand alone, but as with many muni issuers they often procure credit enhancement to get to AAA/Aaa ratings (saves on interest cost for timid muni bond investors that love the idea of a AAA/Aaa rating). The point here is debt is not free. Even if McKinney can get their debt deal done in the mid 2’s, that is still $5.5mm of interest per annum, enough to pay 150 Texas 10 year tenure teachers ($37,000 per teacher). The right be be able to issue debt on a tax exempt basis is a powerful right, in and of itself. Most of the holders of muni debt are the wealthy, the top 10% of taxpayers, with a big concentration in the top 1% of taxpayers. A seemingly paltry 2.5% tax exempt yield is much more attractive when converted to a taxable equivalent basis (TEB) = 2.5% / (1 – marginal tax rate). The 1% are taxed Federal at 39.6% at the margin. There is a 3.8% tax on investment income to pay for Obamacare, but muni interest is exempt making 2.5% tax exempt equivalent to 4.42% on a taxable equivalent basis.

These silos of affluenza are not sustainable, full stop. The World is watching. Smaller government will be a necessity going forward. It will start with towns, which will share essential services (police, fire, education, health care …. high school football stadiums) skimming 20-25% of the bloated unpaid  bar tab for pension and OPEB (Other post employment benefits). Prudent investors should brush up on their Ch. 9 Title 11, Authorization for municipal bankruptcy knowledge. State amalgamation will follow within a decade. We can have a naming competition on the new name for Maine/New Hampshire/Vermont, followed by Washington/Oregon, North and South Dakota, etc.

Each $500bln of frivolous muni debt represent a huge  opportunity cost for the US government. With a weighted average (current) coupon assumption of 2.5% and a marginal tax rate of 39.6% (+3.8% Obamacare tax levy on investments) the Federal tax leakage is 5.4bln (12,500,000,000 of interest income taxed at 43.4%) per annum. Texas has no State tax, the opportunity cost is even higher in the high State tax states like NY and NJ.

All this is happening at a time of near unparalleled uncertainly (GFC aside, but that is a much longer blog …. AIG bailout, TOB – Tender Option Bond Programs, aka “Tons of Blood”, global arbitrage of the steepness of the US municipal interest rate curve gone awry). Puerto Rico (PR), which I have recently written on, will be restructuring their debt, as soon as legally feasible. PR defaulted last week on a large slug of GDB (Government Development Bank) debt. PR’s benchmark 8% 35′ GO’s (General Obligation bonds, top of the food chain from a “priority of payments” perspective) ,are yielding > 13% tax exempt this week (23% + on a taxable equivalent basis even as a Texas taxpayer).

The Federal stance on the PR pension plans will be precedent setting for the woefully underfunded US States. Illinois has the worst pension in the nation (funded 40 cents to the $1), aside from the non-state bastard PR (sub 10 cents funded on a blended basis). IF we see an insolvency at the state level in the next  decade it will be Illinois.

More than 45,000 students in Detroit missed school for a couple of days this week due to the “sickout” staged by teachers, embroiled in a strike. Detroit was the largest city bankruptcy in US history, July 2013 ($19bln).

Something is rotten in the state of Denmark (Shakespeare). JCG

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PUERTO RICO – THE SPOILS OF WAR

“Puerto Rico’s Sinking and I Don’t Want to Swim” was the other top candidate as a header. The current maelstrom has many questioning how the US got into this mess in the first place. Spain controlled Puerto Rico for 4 centuries, from 1493-1898. US victory in the Spanish-American war of 1898 saw Spain cede the Island of Puerto Rico to the US under the terms of the Treaty of Paris. The Spanish relinquished control of Cuba, Guam and the Philippines as part of the same conflict, which lasted a compact 10 weeks (fought in the Pacific and the Atlantic, obviously).

At the time of the 1898 handover, Puerto Rico (PR) had a population of under 1 million (Florida’s Puerto Rican American population is now >1mm). The island population is now 3.6mm, and it has been dropping drastically, as the prospects for the Commonwealth (notably not yet a State) have deteriorated markedly. The 10 year phased roll off of Section 936 tax exemptions for PR domiciled manufacturing under Bill Clinton in 1996 was a partial catalyst. The poverty rate stands at 45%. Labor force participation is low with 41% of the working population opting out (choosing not to work). A full 30% of the employed work for the government. Official unemployment is in the mid teen’s. 40% of personal income in PR comes from transfer payments from Uncle Sam and further 27% of the population is on food stamps.

The US$10bln plus in annual US subsidies to the Commonwealth of Puerto Rico (officially termed “stimulus”) is clearly not the long term solution. An unbroken chain of 7 year of PR recessions (shrinkage in GDP is entering the 8th consecutive year) has been the recent reward. Clearly, allowing an unincorporated US Territory admission to the Union as a State is not the path to salvation either.

There are now more Puerto Ricans living Stateside that there are living in PR (60%/40% split as of 2014). 5mm (including those of Puerto Rican descent), Puerto Ricans live in the US, 29% of them having been born in Puerto Rico. Worthy of note is the fact that the Jones Act of 1917 made all Puerto Ricans natural born citizens of the United States. The last thing we need at this juncture is a sea wall.

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PR-POPULATION

Puerto Rico is all over the press this week on the actions of the PR government to halt payments on their debt through declaring an “Emergency Period” for the GDB (Government Development Bank for Puerto Rico), their financial nerve centre. Governor Padilla previously termed the debt as “not payable” in June 2015. There is a $400mm + interest payment due May 1st hence the “come to Jesus” moment will be soon upon us. There have been efforts to restructure for certain. PREPA (PR Electric Utility) bond holders took a flesh wound haircut of 15% in November 2015. The Commonwealth of Puerto Rico has issued debt via 18 different issuers over the years. COFINA, linking bonds to sales tax receipts has been a popular credit (both insured and uninsured).

While not currently allowed by law (US Congress is working on giving PR the same rights that other US municipalities have under US Bankruptcy laws) a full white flag surrender by Puerto Rico would result in the 7th largest debt default in history. The effects would be far reaching. The full debt tally is pegged at US$160bln or about $44,000 per capita. California, as a comp, is at $11,000 per capita in debt. Ontario, Canada is US$15,600. Detroit was $28,600 before they filed for Ch. 9 bankruptcy protection.

Direct debt of PR stands at $72bln, 80% of GDP. The benchmark Puerto Rico 8% July 1, 2035 GO’s (General Obligation Bonds) are trading in the mid 60’s in price terms (CUSIP 74514LE86 rated Caa3/CC with both ratings on negative watch) . The yield at $66.625 is 12.663%. GO’s are tax exempt securities for US tax purposes and Puerto Rico bonds are triple tax exempt (i.e. not subject to taxation at the municipal, State or Federal level). Muni debt is also not subject to the 3.8% Obamacare investment tax, making it effectively “quad tax exempt”. Converting the low teens tax exempt security yield to a taxable equivalent basis gets you to a 43.40% yield (assuming a 43.4% tax rate and a 23.8% capital gain tax rate). Obviously many bad outcomes are factored in at such distressed levels. Even the bond king, Jeff Gundlach has drunk the cool-aid in moderation (approx. 2-3% weighting in Commonwealth of Puerto Rico 2035 GO’s in his $1.73bln Income Solutions Fund).

http://www.emma.msrb.org/  The official repository for information on virtually all muni bonds (official disclosures, trade data, etc.). An awesome resource for municipal credit.

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Pension Plan Woes:

Arguably a bigger problem is the underfunded pensions in Puerto Rico. The total underfunded tally is $42bln at present.The pension plans stand on the brink of insolvency. The funded portion is approximately 10% whereas the worst in the contiguous states is Illinois at 40%. $25bln+ of the PR pension shortfall is from laughably generous legacy (pre 1990) pensions  (grandfathered) that call for a 75% pension, based on the retirees best 3 years, drawn as early as 55 years of age (with 30 years of service). Tweaks made to the system over time have resulted in the defined benefit model being replaced with a less costly defined contribution plan for participants joining after the year 2000. Full tap out of the pension plans would see conversion to a pay-as-you-go system with a draw of $1bln per annum (a full 11% of the annual PR budget). A full 1/3 of revenue currently goes to debt service.

All eyes are on the US Treasury and Obama, who have signalled support for the preservation of pensions over bondholders by potentially giving pensioners priority of payment over bondholders. This is a very important precedent for municipal finance in the USA and beyond.

330,000 current PR pensioners versus deep pocketed bond investors (many 1%ers, incl. hedge funds) is not that hard to handicap. As Puerto Rico goes, so goes Illinois and California, would be the thought.

Broader market implications:

The US Muni bond market is immense at $3.7tln-$4.1tln (estimates vary). Given the tax exemption, the bulk of muni debt is held by the top 10% of US taxpayers, either held directly or through investment funds. Upwards of 75% of the US fund complexes own Puerto Rican debt. Given the current distressed status of the credit (investment grade ratings are a distant memory) there are few new buyers, as on a suitability metric, there is a skull and cross-bones on the credit. What are termed cross-over buyers, primarily hedge funds, are the ones with the fin piercing the water’s surface recently. Estimates peg hedge fund ownership of PR debt at >20% (par amount). It should be noted many hedge funds call Puerto Rico home as well, fully gated as one would expect in an environment reminiscent of The Wire (without the clever police work). Acts 20 & 22 circa 2012 tax hedge funds at 4%. As an aside, crime has been a big factor in the travails of PR, with the crime index tracing in the mid 60’s versus 50 for the USA. That said, the murder rate in 2014 touched a 15 year low of 681 (down 40% from the official high of 1,164, but some pegged the high at 2,000, more than 5 homicides per day).

Monoline insurers:

Muni debt investors are overall a conservative lot. Monoline insurers have been a long standing fixture of the US municipal market whereby insurers “wrap” the credit risk of the muni (for a fee) to make the debt more saleable in the marketplace due to the higher ratings assigned to the debt. For insured debt, the owner has the comfort that to lose money due to default, they need both the issuer and insurer to default. The mechanic of the payout on an issuer default is different than a credit default swap (CDS). With an insured bond (monoline wrapped) the insurer is on the hook to pay periodic interest and principal payments (i.e. sinking fund payment, final principal repayment) when due, as per the underlying Bond Indenture.

01-FT Monoline Insurers Puerto Rico 12-1-15

What to do:

Monitor the PR situation, especially if you own muni bonds. Monitor to PR pension situation if you are a taxpayer. Opportunities will likely arise out of the ashes. Monitor the monolines, esp. Assured Guaranty (AGO) and MBIA (MBI). Look for excessive spread widening as a potential opportunity to buy investment grade muni credit that widens in sympathy. Closed end funds will likely trade at  deeper discounts to NAV. State specific funds from the high tax states may get unduly beaten up. Get some help with this, as muni investing is a specialized area. Funds are likely the way to go versus discrete bonds given the wide bid/offer inherent in retail clip sizes. For non US tax payers opportunities could arise in taxable muni credit which encompasses closed end funds like Blackrock’s BBN, Pension Obligations bonds (PO’s) and OPEB (Other Post Employment Benefits), all of which are taxable to US investors. Not all jurisdictions have tax treaties, but there is no wht on US municipal debt.

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Many layers to this onion, but I’m beyond my optimal word count. San Juan’s Isla Verde was voted the best urban beach but it is likely to be Isla Rojo for a while. Follow me on twitter @firehorsecaper JCG

Disclosure: 6% weighting in DSL (Doubleline Income Solutions) in my IRA. 10.5% yield. 6.9% discount to NAV (closed end fund).

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