As the European economies struggle, the ECB has hinted of more aggressive monetary stimulus in the form of lower rates and quantitative easing. Thirty year bonds in France and Germany now yield 2.20 and 1.73 respectively. With negative deposit rates, European Banks are encouraged to lend/invest their excess reserves. Many of them have been buying European bonds, helping to drive the prices up and yields down.

Many of these same banks are active lenders in the US markets, specifically to municipal projects. As lending/investment opportunities become less attractive in Europe, their presence in the US may increase. 

As an example, the Florida Department of Transportation (Fla DOT) recently borrowed close to 500 million dollars from a consortium of foreign banks including Soc Gen and Credit Agricole to complete the Interstate 4 Project. In the past, Florida DOT would have issued a muncipal bond to raise this capital. In today's market, a new issue for this project would have cost them approximately 4.5% plus issuance costs as compared to the bank consortium rate of 4%.

Direct bank lending to Municipalities has increased over the past few years and some estimate this to be 60 billion per year. As rates drop in Europe, European banks may become more active lending to municipal projects. This activity highlights the fact that municipal yields for long term projects like this are attractive relative to other investment alternatives. Curiously, the bank activity will reduce the need for primary issuance.

What a difference a week makes. This time last week, the Puerto Rico GO, 8% coupon, maturing in 2035, traded at an 87.50 dollar price or a  9.37 yield. Today they trade at 92 or an 8.85 yield. 

Mind you these are TAX EXEMPT securities, EXEMPT from both Federal taxes and ALL State and City taxes. From a credit standpoint the bonds are secured by a FIRST claim on all General Fund revenues. This claim is before pensioners, police, fire, etc and is Constitutionally protected. The 2015 budget calls for 9.5 billion in revenues and the debt service for all the GO debt is approximately 1.25 billion per year. 

The Puerto Rican bond market has been in turmoil since the end of June when Governor Padilla announced the Recovery Act which detailed the process for Public Agencies to restructure their debt. Some market participants, including the rating agencies, concluded that the Recovery Act was a sign that the Administration was "less willing" to pay their debts. We disagreed and understood this as a sign that the Administration was done writing checks to plug operating deficits from PREPA (electric), PRASA (water), and HTA (Highway) Does the Market Have It Right?.

Last week, PREPA announced an agreement with 60% of their bondholders. The bond holders have agreed to forbear in return for a) the appointment of a Chief Restructuring Officer by September 8th, b) the hiring of FTI consultants and their analysis of the operating model by December 15th, and c) a proposed restructuring plan by March 2nd, 2015. 

At the heart of the issue, PREPA can generate over a billion dollars in savings by converting their production facilities from oil to natural gas, but they need capital to make these conversions and to update their transmission and distribution infrastructure. By working together, the likelihood of fixing PREPAs problems have dramatically increased.

Most importantly, the markets are more convinced that that the General Fund will be protected from future draws to plug the operating deficits of the public agencies, making the GO bonds more secure.....which is why they are on a tear. 

Back in the day (2009 thru 2011) California School Districts issued large amounts of non callable,  zero coupon bonds. Debt service caps forced them to issue these structures at very cheap yield levels; most often cheaper than 7%. 

As background, CA restricts the annual amount of debt service School Districts can pay on their outstanding ad valorem debt  to approximately .05% of property valuations (debt service caps). As property valuations fell, the annual debt service caps also fell and School Districts were prevented from issuing traditional current interest bonds (CIBs) that paid interest on a semi annual basis. 

Creative bankers helped School Districts in need of money (mostly for infrastructure improvements). Bankers projected that property values would increase 3% to 5% per year for the next thirty years; projecting property values would be 3 to 4 times the current valuations. They then calculated the future debt service cap using these future property valuations. Since zero coupon bond investors receive all of their principal and interest at the maturity date, in this case, when property values were projected to be much higher....debt service cap problem solved.

Most buyers of municipal bonds are looking for current income so the glut of zero coupon issuance needed to be sold cheap to attract interest; in many cases these yields were between 7% and 8%. Recently, the State passed legislation preventing the issuance of non call zero coupon bonds longer than 25 years in maturity citing the risk that property valuations may not rise as expected leaving higher property tax burdens on future generations.

Lots has changed since 2009-2011, most importantly, CA property values and debt service caps have increased. Proactive issuers are now taking advantage of this new cap room to issue current interest bonds and using the proceeds to buy back the "cheap" zero structures in the open market.

In our view, this makes complete sense as issuers smooth future debt service,  reduce the risk of higher property taxes for future generations,  AND create " debt service savings" by issuing at lower yields than the yields on outstanding debt (the debt they are buying back in the open market). 

Well done Stockton, Jefferson, and the others that will likely follow suit!!

Last week the Commonwealth proposed a 2.2 billion Puerto Rico Infrastructure Finance Authority (PRIFA) deal backed by fuel taxes. The proceeds of this deal would be used to repay Puerto Rico Highway and Transportation (PRHTA) loans to guess who...the GDB. As a reminder, the GDB is the main source for Commonwealth liquidity. In essence, this would monetize newly passed revenues supporting PRHTA debt; essentially giving the GDB a priority claim. 

Along with the new PRIFA announcement, this Administration has now passed the Fiscal Sustainability Act and the Recovery Act. All clear signs that they will do everything they can to protect the Commonwealth budget.

The media will continue to discuss the legal challenges to the Recovery Act and the fact that States cant make bankruptcy law. PR will argue that the Recovery Act is not a Bankruptcy Law and is a way for them ( a sovereign) to ensure the continued supply of vital public services during a financial crisis. Some legal experts believe the cases will end up in State Court.

The rating agencies and some creditors will paint a negative picture of the administration and color them as "being less likely to pay". We disagree and applaud their decision to stop funding these labor protected and massively inefficient organizations. A crisis may be the only way to make the changes needed to right these organizations and help PR reduce the economic burden of high utility costs.

They ain't kidding, the Commonwealth budget will be protected and therefore the GO and COFINA credits look stronger, not weaker.