CIO WM Research 17 March 2014

Transcription

1 CIO WM Research 17 March 2014 Municipal Brief Puerto Rico Credit & Market Update The Commonwealth successfully sold USD 3.5bn of general obligation bonds last week. Proceeds will be used to repay variable rate debt and allow the Government Development Bank to replenish its own liquidity position. The new debt has an 8% coupon and was priced to yield 8.727% (USD 93.00). The bonds mature in 2035 and feature a six year call option at par which will permit refinancing in 2020, without premium, as market conditions allow. The true interest cost was lower than many anticipated, which we attribute to the market s technical strength and an expectation among crossover investors that they can find a secondary market for the bonds reasonably soon. While the bond issue provides the Commonwealth with some much needed near-term breathing room, it is not a longerterm solution to the island's longstanding fiscal and economic challenges, in our view. Investment in the Commonwealth's bonds continues to pose speculative grade investment risks. We believe the recent improvement in Puerto Rico bond valuations presents an attractive opportunity for risk-averse individual investors still holding Puerto Rico bonds to rebalance and diversify their portfolios. For investors who are intent on seeking exposure to the Commonwealth despite the pronounced credit risk, we prefer the general obligation (GO) bonds and the debt issued by the Puerto Rico Sales Tax Financing Corporation (COFINA, by its Spanish acronym). We believe the bonded debt of public corporations and agencies of the Commonwealth present a higher degree of risk and should be monitored closely. Thomas McLoughlin, analyst, UBS FS thomas.mcloughlin@ubs.com, Kristin Stephens, analyst, UBS FS kristin.stephens@ubs.com, Significant appetite for new issue The size of Puerto Rico's most recent general obligation bond offering was increased to USD 3.5bn at the time of pricing from a planned USD 3bn due to very strong demand. The Government Development Bank (GDB) reports that the transaction was oversubscribed by a factor of 4.5x, with 270 different accounts placing orders. GDB Chairman David Chafey confirmed in an interview with Bloomberg News that the majority of buyers were hedge funds. 1 This report has been prepared by UBS Financial Services Inc. (UBS FS). Please see important disclaimers and disclosures that begin on page 6.

2 The Commonwealth will receive USD 3.2bn from the offering, approximately USD 900mn of which will be used to refinance short-term obligations and swap termination payments. Approximately USD 400mn will be used to fund a capitalized interest account for the bonds. 2 Puerto Rico plans to use the remaining proceeds to refinance certain obligations owed by the Commonwealth and its instrumentalities to the GDB, which will provide the bank with a liquidity infusion of USD 1.9bn. We agree with the Bank's assertion that repayment of all outstanding variable rate debt, excluding a small amount of index-linked bonds, simplifies the Commonwealth's capital structure and reduces market risk. According to the GDB, the Commonwealth retains USD 900mn in additional GO bond capacity following the sale under its constitutional debt limit. Fig. 1: Credit spreads for Puerto Rico GO bonds In bps Jan-13 3-Feb-133-Mar-13 3-Apr-13 3-May-13 3-Jun-13 3-Jul-13 3-Aug-13 3-Sep-13 3-Oct-13 3-Nov-13 3-Dec-13 3-Jan-14 3-Feb-143-Mar-14 PR GO 10 yr - GM GO Aaa/AAA 10 yr PR GO 30 yr - GM GO Aaa/AAA 30 yr Source: MMD, UBS CIO WMR, as of 14 March 2014 Puerto Rico's timing proved to be fortuitous. Investor anxiety over whether the Commonwealth would find enough buyers dissipated in the week prior to sale. The absence of much competition, combined with the sheer size of the deal and a willingness by the Commonwealth to concede venue in case of litigation, captured the market's attention. Credit spreads on 10y Commonwealth GOs narrowed to 625bps as of 14 March 2014 from a peak of 775bps as recently as 18 February, according to MMD (see Fig. 1). At the 30-year spot, credit spreads narrowed to 375bps from 420bps over the same time frame. In a speech following the bond sale, Governor Alejandro Garcia Padilla stated that the bond offering would allow the Commonwealth to meet its obligations for the next eighteen months and that detailed cost cutting measures would be announced in the weeks ahead. Although lower government spending runs the risk of prolonging the economic recession that remains underway on the island, Governor Garcia is focused on private sector job creation as a means of offsetting the recessionary impact of austerity at the government level. Robust trading following the sale After an exceptionally active trading session on 12 March, the total daily trade volume for the new bonds declined steadily in the next two trading sessions. Volume dropped from USD 585mn on 12 March to USD 257mn a day later. After a dramatic rally on Wednesday, bond prices also declined a bit as the week wore on. In the most recent trading session, we observed that dealers were net buyers of this Puerto Rico bond versus being net sellers for the previous trading days, according to Bloomberg data. By Friday (14 March), the average price on the Commonwealth of Puerto Rico's new 8.00% coupon bond maturing in 2035 had declined by roughly ¾ point to USD (8.53% yield) from USD (8.45% yield) one day earlier. This data is based on 138 trades and volume of USD 160.9mn. Roughly 40% of the total number of trades were in amounts of USD 1mn and greater. The frenetic trading in the new bond issue stood in contrast to the subdued activity elsewhere in Puerto Rico debt. We observed significantly lower trade volume in the Commonwealth's more seasoned GO's. For example, just USD 2mn in par amount of Puerto Rico GO 5 ½% due 2017 traded on 14 March based on 16 trades. We attribute the difference to the unique circumstances and size of the new bond UBS CIO WM Research 17 March

3 transaction, in which hedge funds dominated the early trade activity and apparently flipped bonds quickly after the sale. New disclosure addresses outstanding questions In a nod to the demands of traditional investors for more information regarding the Commonwealth's financial condition, the GDB released a quarterly operating supplement and a comprehensive liquidity analysis in quick succession before the sale. The Preliminary Official Statement was comprehensive and carefully delineated the credit risks associated with an investment in the general obligation bonds. Together, in our view, they represented a substantial improvement in the quality of information provided to investors and may have played a supporting role in the strong market reception. We believe investors will remain highly attuned to whether the recent disclosure was an aberration or a welcome sign of things to come. Rating agency feedback Fitch recognized the offering as evidence of Commonwealth's ability to access the market. 3 The rating agency expressed its belief that the transaction's successful execution provides the Commonwealth with breathing room as it continues to address its ongoing fiscal and economic challenges. Fitch also noted that the sale will improve liquidity at the GDB and remove potential near-term liquidity constraints. S&P affirmed its BB+ rating on the Commonwealth's GO debt on 14 March 2014, and also affirmed the ratings on various general fund-supported and highways and transportation authority debt. 4 The rating agency also removed the ratings from CreditWatch with negative implications. S&P described last week's bond sale as a success and, like Fitch, noted that it will relieve near-term liquidity pressure. With the removal of the CreditWatch designation, the rating agency assigned a negative rating outlook to the Commonwealth's debt. While Moody's had not addressed the bond sale at the time we went to press, we expect their reaction to be similarly positive. Public corporations under scrutiny In the wake of the GO bond sale, investors will be closely following the Commonwealth's progress against the Administration's stated fiscal and economic reform measures. Chief amongst these is Governor Garcia's commitment to a balanced budget in FY15. The Governor has promised investors that he would achieve this without further reliance on the capital markets for operating funds. In the absence of any evidence that the economy is expanding, we expect that the FY15 budget must rely upon expenditure reductions in order to be balanced. In addition, we believe it will be essential for the Commonwealth to cease its longstanding practice of providing support for public corporations and agencies across the island. The governor has made it clear that he expects these corporations, such as the Puerto Electric Power Authority (PREPA), to operate without further public subsidy going forward. The legislature, for its part, appears eager to support more comprehensive reforms to wean the UBS CIO WM Research 17 March

4 various agencies off of a reliance on loans from the GDB. Indeed, Governor Garcia and other key members of the legislature have expressed a desire to reform PREPA in order to lower energy costs for some time. Senators Ángel Rosa and José Nadal Power recently introduced legislation (Senate Bill 993) to provide the legal structure by which insolvent public corporations may restructure their debts. In response to market speculation in the wake of the bill's introduction, the GDB and the Treasury Department issued a statement saying that neither the GDB, nor the executive branch, was involved in the in the drafting or formulation of this legislation. 5 According to the GDB and the Treasury Department, the Administration remains focused on creating jobs, balancing the budget, and making public corporations self-sufficient. While the Garcia Administration was not consulted prior to the introduction of the bill, the proposal is another reminder that some legislators may be increasingly reluctant to adopt austerity measures indefinitely. To the extent the public corporations are unable to demonstrate their self-sufficiency absent support from the GDB, a restructuring of outstanding debt remains a distinct possibility, in our opinion. Conclusions The expenditure reductions contemplated by the governor are absolutely essential to ensure a balanced budget in the next fiscal year. Given the market's skepticism as recently as four weeks ago, the bond sale can reasonably be termed a success at a true interest cost below 9%. The Puerto Rico Supreme Court is expected to rule in the next week or two on the constitutionality of legislative reforms to the Teachers Retirement System. The market anticipates that the court will uphold the validity of the law. Absent a surprise decision, we anticipate a brief period of relative tranquility for Puerto Rico. While there will be some media attention devoted to the planned reform of the Puerto Rico Electric Power Authority, the liquidity injection from the bond sale should temper the volatility before investors refocus their attention on the degree to which the borrowing raised the Commonwealth's fixed costs. That said, while the bond issue provides the Commonwealth with some much needed near-term breathing room, it is not a solution to the island's longstanding fiscal and economic challenges, in our view. Investment in the Commonwealth's bonds continues to pose speculative grade investment risks. The liquidity infusion provided by the bond sale gives us greater comfort with Commonwealth GO and guaranteed debt maturities through the end of calendar year For maturities beyond this date, we believe that the recent improvement in Puerto Rico bond valuations continues to present an attractive opportunity for risk-averse individual investors still holding Puerto Rico bonds to rebalance and diversify their portfolios. For investors intent on investing in Puerto Rico, we continue to favor the debt issued by the Puerto Rico Sales Tax Financing Corporation (COFINA, by its Spanish acronym) and Commonwealth GOs over the debt issued by the public corporations and agencies of the Commonwealth. In our view, it may be more difficult for the latter group to achieve balanced operations in the years ahead. UBS CIO WM Research 17 March

5 Endnotes 1 Bloomberg News, "Puerto Rico Lures Hedge Funds for Record Junk Deal: Muni Credit", 12 March GDB, "Government Development Bank for Puerto Rico places $3.5 billion general obligation bonds", 11 March Fitch, "Puerto Rico's $3.5B GO Sale Provides Breathing Room", 12 March S&P, "Puerto Rico General Obligation Debt Ratings Affirmed At 'BB +', Off CreditWatch on $3.5 Billion GO Debt Sale", 14 March As reported by Caribbean Business and Noticel on 15 March We had not obtained a copy of the statement as we went to press. UBS CIO WM Research 17 March

6 Appendix Statement of Risk Although historical default rates are very low, all municipal bonds carry credit risk, with the degree of risk largely following the particular bond s sector. Additionally, all municipal bonds feature valuation, return, and liquidity risk. Valuation tends to follow internal and external factors, including the level of interest rates, bond ratings, supply factors, and media reporting. These can be difficult or impossible to project accurately. Also, most municipal bonds are callable and/or subject to earlier than expected redemption, which can reduce an investor s total return. Because of the large number of municipal issuers and credit structures, not all bonds can be easily or quickly sold on the open market. Terms and Abbreviations Term / Abbreviation Description / Definition Term / Abbreviation Description / Definition GO General Obligation Bond TEY Taxable Equivalent Yield (tax free yield divided by 100 minus the marginal tax rate) MMD Municipal Market Data Rating Agencies Credit Ratings I n v e st m en t G ra d e N on Ī n ve s t m en t G ra A1 A2 A3 Baa1 Baa2 Baa3 Ba1 Ba2 Ba3 B1 B2 B3 Caa1 Caa2 Caa3 Ca S&P Moody's Fitch/IBCA Definition AAA Aaa AAA Issuers have exceptionally strong credit quality. AAA is the best credit quality. AA+ AA AA- Aa1 Aa2 Aa3 AA+ AA AA- Issuers have very strong credit quality. A+ A A- BBB+ BBB BBB- BB+ BB BB- B+ B B- CCC+ CCC CCC- CC C A+ A A- BBB+ BBB BBB- BB+ BB BB- B+ B B- CCC+ CCC CCC- CC+ CC CC- Issuers have high credit quality. Issuers have adequate credit quality. This is the lowest Investment Grade category. Issuers have weak credit quality. This is the highest Speculative Grade category. Issuers have very weak credit quality. Issuers have extremely weak credit quality. Issuers have very high risk of default. d e D C DDD Obligor failed to make payment on one or more of its financial commitments. this is the lowest quality of the Speculative Grade category. UBS CIO WM Research 17 March

7 Appendix Disclaimer Chief Investment Office (CIO) Wealth Management Research is published by Wealth Management & Swiss Bank and Wealth Management Americas, Business Divisionsof UBS AG (UBS) or an affiliate thereof. In certain countries UBS AG is referred to as UBS SA. This publication is for your information only and is not intended as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. The analysis contained herein does not constitute a personal recommendation or take into account the particular investment objectives, investment strategies, financial situation and needs of any specific recipient. It is based on numerous assumptions. Different assumptions could result in materially different results. We recommend that you obtain financial and/or tax advice as to the implications (including tax) of investing in the manner described or in any of the products mentioned herein. Certain services and products are subject to legal restrictions and cannot be offered worldwide on an unrestricted basis and/ or may not be eligible for sale to all investors. All information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to its accuracy or completeness (other than disclosures relating to UBS and its affiliates). All information and opinions as well as any prices indicated are currently only as of the date of this report, and are subject to change without notice. Opinions expressed herein may differ or be contrary to those expressed by other business are as or divisions of UBS as a result of using different assumptions and/or criteria. At any time, investment decisions (including whether to buy, sell or hold securities) made by UBS AG, its affiliates, subsidiaries and employees may differ from or be contrary to the opinions expressed in UBS research publications. Some investments may not be readily realizable since the market in the securities is illiquid and therefore valuing the investment and identifying the risk to which you are exposed may be difficult to quantify. UBS relies on information barriers to control the flow of information contained in one or more are as within UBS, into other areas, units, divisions or affiliates of UBS. Futures and options trading is considered risky. Past performance of an investment is no guarantee for its future performance. Some investments may be subject to sudden and large falls in value and on realization you may receive back less than you invested or may be required to pay more. Changes in FX rates may have an adverse effect on the price, value or income of an investment. This report is for distribution only under such circumstances as may be permitted by applicable law. Distributed to US personsby UBS Financial Services Inc., a subsidiary of UBS AG. UBS Securities LLC is a subsidiary of UBS AG and an affiliate of UBS Financial Services Inc. UBS Financial Services Inc. accepts responsibility for the content of a report prepared by a non-us affiliate when it distributes reports to US persons. All transactions by a US person in the securities mentioned in this report should be effected through ausregistered broker dealer affiliated with UBS, and not through a non-us affiliate. The contents of this report have not been and will not be approved by any securities or investment authority in the United States or elsewhere. UBS specifically prohibits the redistribution or reproduction of this material in whole or in part without the prior written permission of UBS and UBS accepts no liability whatsoever forthe actions of third parties in this respect. Version as per January UBS specifically prohibits the redistribution or reproduction of this material in whole or in part without the prior written permission of UBS and UBS accepts no liability whatsoever forthe actions of third parties in this respect. UBS The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved. UBS CIO WM Research 17 March