Market Update for 2014

Transcription

1 By Matt Posner

2 The world of public debt management has undergone more change in the past two years than it has in the last two decades. A new regulatory landscape has emerged with the Dodd-Frank Act reforms, and after a 30-year bull market, with its steady decline in interest rates, the Federal Reserve appears to be increasing the federal funds target rate soon. It will likely increase borrowing costs for municipal issuers. Meanwhile, the municipal bond industry which was known as the sleepy market for much of its existence is suddenly grappling with new credit trends and negative headlines as a result. Government finance officers need to be vigilant in navigating this changing landscape, especially when raising capital through the municipal market. Outlined in this article are areas that are particularly important to monitor over the next year. MARKET FORECASTS For most bond market participants, the single most important development to monitor over the next 6 to 12 months is whether the Federal Reserve raises the federal funds target rate. (When it rises, interest rates will likely rise, increasing borrowing costs for municipal issuers.) Related trends that finance officers should watch for include the following: Timed Rate Hikes and Investment Exits. Mutual fund investors in recent history have tried to time rate-hikes or exit their investments before rates rise. This behavior has a large effect because mutual funds are the second-largest way investors invest in municipal bonds. In 2013, when investors fled the market, it was not able to digest the number of municipal bond fund redemptions, resulting in one of the most volatile summers in recent history. This year has already experienced rate-related outflows from municipal bond mutual funds. If these outflows continue or increase, issuers costs for capital might rise from 75 to 190 basis points. Growing Interest from Institutional, Opportunity- Oriented Investors. As mutual fund investors force redemptions, institutional investors are likely to moderate volatility by staying in the market, as they have done in the past. Banks The municipal bond industry which was known as the sleepy market for much of its existence is suddenly grappling with new credit trends and negative headlines. and insurance companies have played a greater role as municipal bond investors during the last 18 months in fact, banks have increased their municipal holdings by more than $60 billion during this time, according to Federal Reserve flow of funds report data. These data are publically available and can help finance officers in discussions with their advisors before coming to market because different types of investors are active during different times. A Drop in Issuer Refundings. The 2015 trend of global interest rate increases has narrowed or closed the opportunity for municipal refundings. May and June 2015 municipal issuance data (from Bloomberg) showed a drop in issuer refundings as rates rose during those months. We expect refunding volume to diminish as the rate environment grows more adverse. This, coupled with a sustained drop in new-money issuance, could result in a net decline in overall issuance volume in the second half of the year a silver lining for issuers planning to borrow in 2015, as the supply/demand balance becomes more favorable. MARKET TRENDS Perhaps the most important market stresses for issuers in the near term have to do with the situations in Puerto Rico and Chicago, Illinois. Earlier this summer, Puerto Rico s governor told the New York Times that its debt load was not payable 1 and as a result, the island will likely see a broad restructuring and probably default on a significant portion of its $70 billion in outstanding debt potentially the largest default in market history. This scenario, which has since come to pass, affects the general market. Mutual fund investors tend to react quickly to negative press and in most cases, mutual funds that own a substantial amount of Puerto Rico bonds (because they are exempt from federal, state and local taxes) also own other municipal bonds. Thus, when faced with investor redemptions, funds will sell bonds that are more liquid (i.e., higher-rated credits from across the country), creating negative pressure on the broader market. Moody s May 2015 downgrade of Chicago to junk status the result of the city s inability to create a viable pension August 2015 Government Finance Review 39

3 funding plan has already borrowing costs across the country. Just after the downgrade, Chicago s bonds traded at significantly higher yields (which was expected). Soon after that, the market for the State of Illinois general obligation (GO) credit rating not related to Chicago s GO, although the state has its own pension funding concerns also began to trade cheaper. Next, the State of New Jersey which is dealing with its own pension issues saw its appropriation-backed debt begin to trade at 40 to 60 basis points cheaper in secondary markets in response to the Chicago downgrade. (Large institutions sold the New Jersey bonds, looking to unload exposure to another credit that could face similar pension-related downgrades.) Recall that trades in the secondary market on fixed-coupon bonds will not affect an issuer s borrowing costs because the levels were fixed during issuance. But when the bonds begin to trade Government finance officers need to be vigilant in navigating the changing landscape, especially when raising capital through the municipal market. cheaper in secondary markets, as was the case for New Jersey, it sets new expectations for when the issuer has to come to market in the future. Thus, New Jersey s borrowing costs on its appropriation-backed debt are expected to be higher in the future, in part because of the downgrades in Chicago. The contagion did not stop there. In the weeks that followed, Pennsylvania and Connecticut states that also have challenging pension liabilities were forced to pay higher borrowing costs in bond deals (see Exhibit 1 to see how the market is penalizing Illinois, New Jersey, Pennsylvania and Connecticut). An unrelated credit event (in this case, Chicago s downgrade) has rarely had such a distinct negative impact on the borrowing costs of states and localities. As such, issuers should consider and monitor the broader ramifications of elevated investor focus on pension liabilities. Exhibit 1: State GO Basis Point Spread to MMA AAA and 10 Year Yield n June 30, 2015 n 10 Year (percent) Basis Points Yield Percentage PR IL NJ PA CT MI WA CA WI OH TX MA FL MD MN SC NY TN GA VA NC MMA 0 40 Government Finance Review August 2015

4 RATING TRENDS In recent years, Standard & Poor s and Moody s Investor Service have altered rating methodologies for municipal sectors. Trending positive: S&P released a new methodology in 2013 for local government GO credit ratings, which was part of the agency s efforts to make the rating assignment process more transparent and its results more contextualized. Because of municipals inherently positive credit factors and their strong repayment performance relative to other sectors, this has a net positive result. Trending negative: Moody s has refined its methodology to increase the importance of pension liabilities on rating outcomes and affirmed its negative outlook on the local government sector. Local government issuers may want to review each rating agency s updated criteria to determine whether they are likely to be affected. The 2015 trend of global interest rate increases has narrowed or closed the opportunity for municipal refundings. quarter of 2015, uninsured, singlerated new deals made up 48 percent of all new issuance (compared to 33 percent in 2008). This increase can be attributed to issuers looking to lower borrowing costs because of budget pressures, the increase in rating fees, and growing regulatory expenses. But less credit information can undermine retail investor confidence and increase yields on new bond offerings for issuers that choose to go with a single rating. A decline in ratings use can also provide less credit guidance to issuers themselves, as many decision makers at the state and local level use ratings as a tool to guide and legitimize financial decisions. Finance officers making rating decisions should include these factors in their decision making because more single ratings are expected in the near term, which may only exacerbate the themes mentioned previously. Split Ratings. These new criteria have increased issuers split ratings (when the agencies assign different ratings to the same issuer). In 2014, the number of issuers with different ratings from Moody s and S&P increased to 46 percent on all investment-grade rated bonds a trend that seems unlikely to abate in the near future. The effect of split ratings is negative because it can erode confidence in the ratings themselves and reduce the pricing relevance of ratings. As a result, investors tend to rely more on their internal credit research, which exposes issuers to a broad array of creditrelated concerns (i.e., specific concerns outside of traditional factors such as pension funding, state oversight of a local issue, and/or continuing disclosure practices). Issuers don t know what factors will be important to different investors in a bond deal, making the price expectations much more challenging. Further, to the extent that diverging opinions make a credit profile more ambiguous, the role of non-credit related factors such as the size of the bond deal, a specific call or coupon structure, or even the timing of a bond deal become more relevant. Once again, these factors add more unknowns to a bond deal, and split ratings may make them more relevant. BENCHMARKING AND TRANSPARENCY Benchmarking is an important practice when pricing bonds, and the Municipal Market Data (MMD) AAA yield curve is the most commonly used tool for municipals. The use of benchmarks has also become more important to the Single Ratings. Perhaps a more important shift has been the increased use of a single rating. Through the first August 2015 Government Finance Review 41

5 regulatory community, to help issuers evaluate their cost of issuing bonds and to help investors make decisions. The Municipal Securities Rulemaking Board (MSRB) may be adding more pricing information to its Electronic Municipal Market Access (EMMA) system to create greater transparency and provide trading information. While many government officials are well versed in using benchmarks to evaluate their investment portfolios, they do not understand the critical role MMD plays in their eventual municipal borrowing costs. What is MMD? MMD is a set of theoretical yields for AAArated state GO bonds that mature from two to 30 years. It is the guide many market participants use to discern prices in the market. The data set is determined by the MMD analyst team and the curve represents the MMD analyst team s opinion [emphasis added] of AAA valuation based on institutional block size market activity in both the primary and secondary municipal market. 2 Thus, the day-to-day inputs are subjective and there are no other clear guidelines in how the information is created. This means that issuer borrowing costs are associated with a market opinion, the construction of which is not well understood. MMD s Current Significance. Most municipal bond deals are anchored to MMD, so it directly correlates to the cost of borrowing. Most other fixed-income markets price bonds relative to an index or a highly traded security. For example, most corporations issue their bonds at a defined basis point spread over a U.S. Treasury bond. When a municipal issuer plans to sell bonds, it often has several conversations with its municipal advisors and underwriters about the types of prices to expect. In a negotiated sale, price views are circulated to potential investors that in many cases offer the price as a spread to MMD or how many basis points higher or (sometimes) lower than the MMD dataset. Unlike their corporate counterparts, there are no widely adopted transparent indexes for municipal bond deals. Instead, the financial professionals aiding an issuer will make a decision to offer a certain amount of yield relative to where MMD was published that day. For most bond market participants, the single most important development to monitor over the next six to 12 months is whether the Federal Reserve raises the federal funds target rate. Burden of Proof. It becomes more important to keep in mind that MMD reflects an opinion, not an index of underlying securities, when considering the rules that the Internal Revenue Service (IRS) has proposed for underwriters and issuers when pricing bond deals. The IRS s proposed price guidance, published in June 2015, revised the standards for what establishes the initial offering price of bonds. If those standards are not met, and the underwriter changes prices to correspond with the market, the burden of proof to establish the issue price must be based on a broad-based index of municipal bond interest rates on bonds similar to the type and credit rating of the bonds being sold. 3 This burden of proof can become an issue because bond prices are likely directly linked to MMD s opinion, which is not an index. The standard set forth could be problematic for market participants current practices. It also calls into question why a deal should be tethered to MMD, if the standard the IRS is setting forth requires an index of broad-based securities. Increased Transparency. The Securities and Exchange Commission s municipal advisor rule imposes a fiduciary duty on municipal advisors when involved in a bond pricing. MMD s role in the final cost of borrowing should be made clear in this context. For example, when bond prices change from retail to institutional order period, in many cases the change is simply driven by the MMD curve change not a thorough review of market factors or specifics of the particular deal/credit. Given the opaque process of the MMD curve, an issuer s fiduciary should reach an independent understanding of the situation so he or she can clearly explain why the cost of borrowing changed or how it was calculated to begin with. Having a greater understanding of the ins and outs of bond pricing will help finance officers gain a deeper knowledge of market influences and fluctuations that can result in more favorable negotiations when bonds are sold. That along with additional pricing information on EMMA, and having regulators look at incorporating true indexes into the municipal sector, would be beneficial to issuers and the municipal marketplace as a whole. 42 Government Finance Review August 2015

6 CONCLUSIONS Notes While access to the municipal bond market remains strong for most governments for now, the landscape will continue to evolve because of changing federal regulations and corresponding market practices. Finance officers should brace for an eventual rising-rate environment, along with the associated challenges. The problems being experienced by Puerto Rico and state and local governments that have pension funding concerns will not disappear if your credit is not subject to related problems, that is an important message to convey to investors. Additionally, expect rating agencies to continue to diverge in how they assess municipal credits and plan appropriately. Finally, pricing transparency will likely grow as a topic affecting issuers and investors. y Chicago s May 2015 credit rating downgrade to junk status, the result of the city s inability to create a viable pension funding plan, has already affected borrowing costs across the country. 1. Michael Corkery and Mary Williams Walsh, Puerto Rico s Governor Says Island s Debts Are Not Payable, New York Times, June 28, Understanding Municipal Market Indices, Yield Curves, and Benchmarks, Municipal Securities Rulemaking Board, September Issue Price Definition for Tax-Exempt Bonds, a proposed rule by the Internal Revenue Service, June 24, MATT POSNER is a managing director at Municipal Market Analytics, a Massachusetts-based independent data and research firm. Mr. Posner writes daily municipal market Insight reports and coordinates the firm s Washington D.C. initiatives. He also oversees the weekly MMA Municipal Issuer Brief, a report designed exclusively for the issuer community. To sign up, contact Posner.matthew@gmail.com. August 2015 Government Finance Review 43