The Selling of Puerto Rico's Sales Tax Bonds
This week's Federal Open Market Committee (FOMC) meeting was supposed to be a non-event. It turned out to be a bit more than that. The Committee's statement was perceived to be more hawkish, or at least less dovish, than what market participants were hoping for. By removing just one key line from the previous statement – "tightening of financial conditions(…) if sustained(…) could slow the pace of improvement" – the FOMC came across as being much more sanguine about the outlook for the economy than expected. Needless to say, most traders were caught leaning the other way, going into this week's proceedings.
So far, the U.S. manufacturing sector also appears unfazed by October's debt ceiling debacle. The Institute for Supply Management (ISM) Index rose to 56.4 in October, its highest level since April 2011. This strong reading came a day after the Chicago PMI data also showed a sharp rebound.
And so, just like that, the yields on the 10-year and 30-year Treasury bonds have now backed up to around 2.63% and 3.70%, respectively. October's rally has effectively been erased.
The next big test for the markets will be the October non-farm payrolls report, which has been delayed to next Friday, October 8th, due to the government shutdown.
The municipal market did manage to outperform government bonds this week, with some help from the November 1st reinvestments, with yield levels dropping between 17 and 20 basis points over the course of the last 8 trading sessions. As a result, muni ratios have declined sharply to 95% in the 10-year range and 111% in the 30-year range. With Treasuries continuing to sell off, the rally finally petered out in late Friday trading.
So far, the U.S. manufacturing sector also appears unfazed by October's debt ceiling debacle.
Outflows from municipal bond mutual funds continued for a 23rd consecutive week, but at a more moderate pace. Funds that report flows weekly recorded outflows of $503 million for the week of October 30, according to Lipper. The high-yield muni funds that report weekly actually saw flows turn modestly positive, to the tune of $37 million, compared to withdrawals of $68 million the previous week.
Whenever mutual fund flows will turn around, it won't be soon enough for the tax-exempt market. Over the past three years, according to a recent Bloomberg report, commercial banks have been stepping up their involvement in the tax-exempt market. Now even that source of demand could be in jeopardy. The reason? The Federal Reserve is floating a proposal that excludes state and local debt from a list of market instruments that would satisfy the new liquidity rules banks have to comply with. The Fed's new rule is expected to gradually phase in from 2015 through 2017.
"Selling" COFINA
Since the October 15th webcast, the Commonwealth of Puerto Rico has certainly come through on its pledge to improve its disclosure practices. Particularly when it comes to its only lifeline to the capital markets, i.e. the sales tax financing structure also known as Cofina, the Puerto Rico GDB is not taking any chances. Yesterday, the GDB hosted another investor call to re-affirm the security structure for Cofina and dispel investor concerns about potential "clawback" of sales tax revenues by G.O. bondholders under a default scenario.
The call featured an array of attorneys from both US-based counsel (Nixon Peabody) and local counsel (Pietrantoni, Mendez & Alvarez), who took turns to re-affirm the legal opinions that were delivered in conjunction with the Cofina Senior Series 2011C and 2011D.
Basically, in the counsel firms' opinion, the portion of the sales tax assigned by Law 91 to Cofina (or any other revenue enacted to replace the sales tax revenues) does not belong to the category of "available resources" for G.O. bonds and therefore should not be subject to clawback by G.O. bondholders claiming fraudulent conveyance or preferential transfer. The PR Secretary of Justice has also delivered a legal opinion to the same effect and this opinion apparently enjoys broad bipartisan support as it has been issued by four different Secretaries of Justice, serving three different administrations of alternating political parties.
While we won't spend time re-hashing the legal opinions, which you can check out for yourself on the GDB's website, we do have a couple of interesting takeaways from the call.
First, the attorney from Nixon Peabody noted that theirs is only a "reasoned opinion", based on a reasonable interpretation of existing statutes, but one that cannot really be "proven" due to the lack of legal precedent under PR law. This of course led a member of the audience to ask why Cofina hasn't sought an advisory ruling from, for instance, the PR Supreme Court.
… could this be one of the potential solutions to the Commonwealth's fiscal crisis?
The response from the representative of the Justice Department was summarized in a later press release as follows: "In contrast to other state jurisdictions but similar to the standard applicable in federal court, Puerto Rico law establishes a matter may come before a court only if a real 'case or controversy' exists. As a result, COFINA has not sought and may not seek an advisory ruling or opinion from the Puerto Rico Supreme Court on any matter." In other words, no one can ask for an advisory ruling until an actual trouble situation has occurred.
In another notable point, one of the attorneys from Nixon Peabody, who was presumably involved in the New York City debacle back in 1975, drew a parallel between the lockbox mechanism set up for the New York Municipal Assistance Corporation (MAC) and that of Cofina. If you recall, MAC was an independent corporation created by the State of New York to provide capital market access for New York City after it was, for all practical purposes, shut out of the market. As part of the creation of MAC, the state passed legislation that converted the city's sales and stock transfer taxes into state taxes, which were then used as security for the MAC bonds without ever passing through the city's General Fund.
Upon hearing this, our immediate thought was: could this be one of the potential solutions to the Commonwealth's fiscal crisis? A MAC-like oversight entity with independent revenue sources? Interesting food for thought…
Needless to say, at the end of the day, the more airtight the security for the Cofina bonds is perceived, the worse the Commonwealth's G.O. bonds will suffer in the event of default. Without clear legal precedent, there really is no way to predict how things will ultimately turn out in a bankruptcy scenario (or the equivalent thereof, since PR cannot officially file Chapter 9). Just ask the Detroit bondholders.