Trouble in Paradise for Municipal High Yield Issuers
The municipal bond market has seen a great deal of turmoil recently as credit quality has assumed “center stage”. Historically municipal bonds have been generally viewed as high quality investments and credit issues have been relegated to municipal bond high yield project revenue bonds. “Junk” municipals have typically been a backwater in the municipal bond industry and have been dominated by smallish bond issues. Recently, however, some large issuers have encountered problems in the market, most notably Detroit and Puerto Rico. Detroit has been a problem child in the municipal bond market for quite some time now, as it is hardly news that the American automobile industry has been in a long slow decline covering several decades. Push has come to shove for Detroit as the city grapples with financial obligations that far exceed their ability to repay. Those standing in line waiting for obligations to be met are bondholders, pensioners, city workers and unions and city residents. The situation is so overwhelming that the city has filed to go into Chapter 9 bankruptcy and has initially suggested that bondholders should receive as little as 10 cents on the dollar. While there are some legal challenges to the bankruptcy which are currently pending, the prospect of bondholders getting such a low recovery is alarming. Traditionally, municipal bond investors have relied upon the ability of state and local governments to raise taxes in order to pay general obligation bonds As a result investors have long regarded general obligations to be safe, but now it is clear that raising taxes and other options such as cutting jobs and selling assets will not be enough in Detroit. Too much has been promised by politicians who are now long gone.
Detroit owes somewhere in the neighborhood of $18-20 billion, much of it to bond insurance companies. Puerto Rico, another municipal credit in the news recently, has approximately $70 billion and represents a more systemic risk to the municipal market. While Puerto Rico general obligation bonds are still rated investment grade by all three ratings agencies, bond investors have begun to look ahead, perhaps spurred by Detroit’s potential scary outcome. Puerto Rico is heavily dependent upon access to the bond market in order to fund chronic deficits and a ratings downgrade could severely limit that access. As a result, some investors have jumped the gun and sold bonds. The selloff in Puerto Rico, which some have said is overdone and others have said is warranted, had pushed yields on the islands’ bonds to about 9% (they have since declined to 8.50%).
What does this mean for the municipal high yield market? Big-time competition in terms of yield. In fact, there have been very few senior living bonds priced and sold in the last few months. A quick look at the calendar for new issues reveals that more than a few borrowers are all teed up and ready to go, but the market is not where it was when feasibility studies or refunding scenarios were drawn up several months ago. How long will this last? The Puerto Rico situation is unlikely to be resolved for some time, although a better understanding of its options should become clearer over the next few months. In the meantime, the bonds remain investment grade and are available at eye-popping yields in a return-starved world. Stay tuned.