It has been almost a year since our book Adventures in Muniland was released, during the week before Puerto Rico defaulted for the first time, on August 1, 2015 – see . Our book, a comprehensive guide to municipal bond investing in the post-crisis era, featured a full chapter on Puerto Rico.
Now Puerto Rico is once again a headline story, as its failure-to-pay fiasco continues. On Monday, Puerto Rico was due to make a $422 million debt payment. The government paid $22 million in interest, but it missed a $367 million principal payment. The government also swapped $33 million worth of debt coming due Monday for new debt with later maturities. (Wall Street Journal)
A May 2 piece by Ike Brannon of Realclearmarkets.com, entitled “Puerto Rico Contagion Will Cost Taxpayers”, examines pending House of Representatives legislation on Puerto Rico debt and the implications of the legislation for creditors, taxpayers, and the municipal bond market.
We will excerpt:
“Puerto Rico insists (with Treasury’s support) that any legislation to fix their plight include giving a debt haircut to all creditors, even those investors who own the just over $18 billion of secured debt that is backed by the full faith and credit of the Commonwealth. For perspective, that’s slightly more than 25% of the island’s $72 billion of debt. The bill negotiated by the House Natural Resources Committee acquiesces to these demands; even though it parrots the rhetoric that this in no way constitutes a bankruptcy, the bill incorporates over 100 line items from Chapter 9. However, summarily setting aside a constitutional guarantee in Puerto Rico would set a precedent for other states to do likewise when they face their own debt problem, a day that is unfortunately coming sooner rather than later. Several states have explicit promises both to bondholders and state pension recipients that they will not see their promised payments reduced. Clearly, a state that becomes insolvent cannot honor both promises – want to bet which one gets dropped first? These events are not that far away. There are already law firms working on a possible Chapter 9 bankruptcy in Chicago, and Illinois’ enormous pension problems will likely result in it needing to restructure debt in the next few years as well. The recent Chicago Board of Education bond issuance even required specific language that discussed contingencies in a non-existent bankruptcy regime.”
Note the reference to Illinois. We recently published a guest piece on the pension promises made to teachers in Illinois. (See http://www.cumber.com/more-revealed-in-illinois/.) The anecdotal evidence in that discussion speaks volumes about why the State of Illinois is sinking into its own version of the Puerto Rico debt abyss. We do not expect to see any political will applied toward any favorable outcome. In our firm we take a very dim view of Illinois school credits, and we distrust the general obligation pledge of the state.
Now bubbling up beneath the surface is a political force aimed at mounting a legislative attempt to avoid payment on bonds. Brannon discusses that development in the column cited above. It is a growing risk in the United States. We have already seen it in cities like Detroit and Vallejo, California. We see it in Puerto Rico, and we see political movement in that direction in Illinois and New Jersey.
Atlantic City is the premier case study in NJ. It is an ugly story of deteriorated credit and a political impasse between the New Jersey legislature and the governor, Chris Christie. Simply put: NJ’s governor wants powers to reconstruct the financial situation in Atlantic City. As this commentary is written, Atlantic City has not yet defaulted. The legislature will give Governor Christie power to intervene but will not give him the power or the tools to rework the city’s finances. So Christie has said “No deal.” We don’t blame him. The legislature will not fund what is needed, and it won’t empower the reorganization of contracts, so it is forcing debt default. That outcome imposes a cost on the entire state and its political subdivisions at all levels.
Realclearmarkets.com asks a very important question in this political campaign year. What position will our next president take on these debt-default issues? Does Hillary Clinton favor preserving pension promises in Illinois over paying the bondholders who provided the money to build the schools? Or does she want to invade the federal treasury for the money to pay both? What would Donald Trump do under these circumstances? And if Clinton is president, what will the House and Senate look like when there is a legislative fight over these issues in 2017? Likewise, what will these two chambers look like if Trump is elected? (We could ask the same questions with regard to other presidential hopefuls, but it is looking more and more like those questions are moot.)
As for New Jersey, the markets are already extracting a price. One can measure it in credit spreads. Here is an example. With the help of Amy Raymond, who is a veteran on Cumberland’s internal account management and trading desk, we reviewed some comparative yields. We purposefully selected intermediate maturities and centered the comparison on 2029. So we are talking about 13 years to final payment. We selected bonds with the same coupon rate – in this case they are all at 5% and therefore at premium prices above their par value. We took New Jersey as the center rating – think of it as an “A” credit by all three ratings agencies.
Using live trading prices we found that last week this type of New Jersey general obligation bond was trading at an effective interest rate of about 2.8%. New Jersey is the second-worst credit-rated state in the country. Only Illinois is rated lower than New Jersey. Think of it as having a “BBB” rating. In our analysis, the comparable Illinois bond was trading in live transactions at about 3.5%.
We then took the next two states that are ranked above New Jersey but close to it. Those states are California and Connecticut. Think of these two states as weak versions of an “AA” credit. The comparable bond structure yield in live transactions was about 1.9%.
So here is the summary for these four large states of general obligation bonds with intermediate maturities from live transactions. Illinois at 3.5% is trading at 70 basis points (7/10 of 1%) higher than New Jersey’s 2.8%. Connecticut and California are trading comparably at 1.9%, or 90 basis points (9/10 of 1%) lower than NJ.
Here is our conclusion from this small sample. The taxpayers of Illinois are incurring interest costs of almost 3/4 of 1% more than taxpayers of New Jersey are. And the taxpayers of New Jersey are paying almost 1% more than those of California or Connecticut. Credit spreads tell a story of political failure. Here is the proof with market-based prices of seasoned securities.
At Cumberland we are focused intensely on credit. We will run early from trouble when we see it coming. We are not a mutual fund. All or our accounts are separately managed and fully transparent to every client. The client can see what tax-free and taxable municipal bonds are in his or her accounts every single day. Clients have access to us to discuss those bonds and to question why they are there and what we think about the holdings. That is how a tailor-made investment objective works with a separate account manager.
We don’t trust governments. We equally dislike any dysfunctional political party system, whether Democrat or Republican, Whig or Tory.
And, finally and most importantly, we want our clients to get paid.
David R. Kotok is Chairman and Chief Investment Officer at Cumberland Advisors