Why you can't ignore Puerto Rico's bankruptcy

Puerto Rico's bankruptcy is poised to threaten the livelihood of American citizens who planned their retirement on the island's promises, bludgeon investors and undermine state governments.

The bankruptcy may also provide hope of fiscal sustainability and improved services for Puerto Rico, as the U.S. territory attempts to dig out of $74 billion in debt and $49 billion in pension promises.

But the ripple effects remain shrouded in uncertainty as the U.S. judicial system runs, for the first time, a debt-cutting legal process known as Title III of a 2016 law dubbed the Puerto Rico Oversight, Management and Economic Stability Act (PROMESA).

"Nobody really knows exactly what’s going to happen," S&P Global Ratings credit analyst David Hitchcock said in an interview. "It’s highly uncertain."

To be sure, the legal process is similar to the Chapter 9 municipal bankruptcies of Detroit in 2013 or Orange County, Calif., in 1994.

An oversight board governing Puerto Rico will aim to negotiate debt-cutting deals with creditors with the goal of achieving a viable "plan of adjustment" that a federal judge deems reasonable and fair.

But previous municipal bankruptcies have demonstrated that the clash between Wall Street creditors, mom-and-pop vendors, retirees, politicians, union officials and special interests is a recipe for inertia.

"I don’t know that a dawn is coming, but it’s going to get darker," Municipal Market Analytics analyst Matt Fabian said in an interview.

What's clear, however, is that in the absence of action, Puerto Rico's downward spiral will continue, as the island's economy remains distressed and as thousands of people flee to the mainland.

© THAIS LLORCA, EPA People face off with police during the general strike against austerity measures, which coincides with the International Workers Day, in San Juan, Puerto Rico, on May 1.

To many Americans, Puerto Rico is a vacation spot and nothing more. But this bankruptcy could hit closer to home than they realize. Here's why.

Fellow American citizens could continue to suffer.

Puerto Ricans are American citizens. Their home is our home, and ours is theirs. They are suffering under the weight of heavy debt, government bureaucracy, high taxes and poor access to economic opportunity. 

This bankruptcy may lead to their pensions and health care insurance taking hits, while services could also suffer cuts. Fabian estimated that some pensioners may get cuts of up to 20%.

But that may be necessary to help stabilize the island. Puerto Rico has lost 20% of its jobs since 2007 and 10% of its population, sparking an economic crisis that worsens by the day.

Still, without action to improve services such as public safety, health and education, the island's population loss could continue or even accelerate.

Your retirement investments may take a hit.

Since Congress voted 100 years ago to exempt Puerto Rican bonds from federal, state and local taxes, those investments have attracted many people seeking tax-free retirement income.

Despite years of trouble, more than 40% of U.S. municipal bond funds still have exposure to Puerto Rico debt, totaling $7.82 billion in holdings, according to Morningstar data provided to USA TODAY.

What's more, U.S. mutual funds hold about $8.38 billion in Puerto Rico debt, according to Morningstar.

Those bonds could be subject to steep cuts in bankruptcy, and while insurance may cover some of those losses, anyone who bet their portfolio on Puerto Rico should be nervous.

The bankruptcy "could have the advantage of a potentially global solution that might arrive more quickly and with lower legal costs, but it also strengthens Puerto Rico's protection against legal claims," Hitchcock said in a research bulletin.

It might be more expensive for your state to borrow.

Puerto Rico's crisis shows that large governments can reach a point of no return, endangering investment principal.

That may give investors pause before they acquire debt from cash-strapped states and cities, Fabian said. That could increase borrowing costs for state and local governments, which must cut spending or raise taxes to make up the difference.

"I think it will make life more difficult in places like Illinois and New Jersey and Connecticut, where investors are already reluctant to loan the government money," Fabian said. "It’s going to increase investor trepidation."

The case could lead to a political eruption in Washington.

Although Washington's response to Puerto Rico's action was largely muted Wednesday — it was, after all, not unexpected — the unintended consequences of PROMESA may soon trigger a political firestorm.

If and when discussion of pension cuts heats up, expect angry missives from members of Congress — perhaps even from lawmakers who voted to create this debt-cutting process in the first place. Others may be upset about bondholders taking cuts.

"Members of Congress have a variety of interests in what sacrifices are made in this restructuring," said Melissa Jacoby, a University of North Carolina professor and expert on municipal bankruptcy.

But don't expect a bailout anytime soon. President Trump has blasted the possibility of rescuing Puerto Rico, and it's highly unlikely Republicans on Capitol Hill will show any interest.

Even Buying Puerto Rico Bonds Near Record Lows Isn't a Sure Thing

• Island turning to court to shed some of its $74 billion debt

• Analyst says of outcome: ‘I don’t know how to model it’

Puerto Rico bonds are trading near record lows, but that doesn’t mean they’re not worth even less.

The island triggered the start of the largest U.S. municipal restructuring in history yesterday, nearly two years after it began defaulting on its $74 billion of debt. Puerto Rico has said it can pay less than a quarter of what it owes to creditors over the next ten years, even after it enacts sweeping measures to stabilize the government’s finances.

The prospect of deep losses -- despite vast uncertainty about how large such haircuts will be -- caused some bond prices to tumble in March, as investors sought to gauge how the governor’s fiscal plan would divvy up the island’s scarce cash. Puerto Rico general-obligation bonds due in 2035, one of the most frequently traded securities, sold for an average of 65.2 cents on the dollar Thursday, while sales-tax bonds with the greatest claim on those funds traded at 58.4 cents. Some highway agency debt traded for 23 cents.

"I think there’s a lot of downside risk to these prices," said John Miller, who oversees $120 billion of municipal bonds at Nuveen Asset Management in Chicago, including a small amount of insured Puerto Rico debt. "It’s maybe a message that creditors are not interested in compromise and they want to prove that they are entitled to more of the island’s resources and more of the prioritization scheme."

Miller said even the governor’s plan to pay less than a quarter of the debt service that’s due over the next decade could prove too optimistic, as that relies on the government improving its tax collections by cracking down on scofflaws, something it has struggled to do the past. At the same time, some creditors are more optimistic, insisting that Puerto Rico has the ability to pay more for debt service than it claims.

All of Puerto Rico’s bonds have the three lowest credit ratings from Moody’s Investor Service. The rating agency projects 65 percent to 85 percent recovery rates for bonds such as the general obligations and senior sales-tax debt. It forecasts holders of the Government Development Bank will recover less than 35 percent.

Matt Fabian, a partner with Municipal Market Analytics, said even though he thinks prices will fall further, he doesn’t know how anyone would calculate what final recoveries will be. Municipal bankruptcies are extremely rare, and Puerto Rico’s is rarer still, relying on a special, tailor-made procedure that Congress included in its emergency rescue law.

"I don’t know how to model it. I don’t think that Puerto Rico’s recovery is model-able," Fabian said in a telephone interview. "There’s so much uncertainty over what final recoveries will be, not the least of which is time. Bondholders are likely to be left with certificates when this is done. I don’t know how you price recovery, but based on what the commonwealth believes it can pay, prices are too high."

Not every one is as pessimistic. Peter Hayes, a managing director at BlackRock Inc., said that the current prices probably reflect most of the downside risk going forward as the bad news has already been factored in.

"It’s hard to believe that there will be very big surprises from here that will change the value of the bonds," he said. "With that said, there’s probably not a lot of upside either."

Puerto Rico Collapse Shows Debts Seen as Ironclad May Not Be (2)

(Bloomberg) -- Puerto Rico’s decision to use a U.S. court to escape from its debts cast few ripples in the state and local bond market, where prices rose Wednesday. But the action -- once inconceivable for a territory that didn’t have authority to file for bankruptcy -- sets a precedent that could resonate with struggling states in the decades ahead.

The island was extended the bankruptcy-like powers by Congress as a way to end an intractable crisis, despite the assurance once given to investors that it couldn’t be done. While state finances are largely on the mend and officials have dismissed any suggestion they would ever push lawmakers for the same legal recourse, the path ceded to Puerto Rico has fostered speculation it may one day look attractive to governments at the end of their financial ropes.

“There’s a cautionary tale here across the board,” said Jim Millstein, founder of Millstein & Co., which served as financial adviser to Puerto Rico under former Governor Alejandro Garcia Padilla. “Municipal debt, state debt, federal debt, sovereign debt is not without risk. The truth is that bondholders get paid based on the health of the economy of the issuer.”

Puerto Rico’s restructuring will be the biggest in municipal-bond market history, vastly larger than Detroit’s $18 billion record bankruptcy, and will mark the first time a state-level issuer has had debt written off in federal court. It comes after years of borrowing to pay bills as the economy shrank and residents left for the U.S. mainland, leaving the government without enough revenue to repay what it owes.

The island had been expected to resort to such a step ever since Congress enacted legislation last year that allowed for it. There was no discernibly negative impact from the news on the financial markets, with yields on an index of top-rated 10-year municipals slipping to 2.15 percent. Nor did it have a big effect on Puerto Rico bonds: a commonwealth general obligation with an 8 percent coupon, one of the island’s most-actively traded securities, changed hands for an average of 65.2 cents on the dollar Thursday, up from 64.7 cents on Tuesday, ahead of the court filing.

“Puerto Rico’s just been in the news for so long we know it’s in default,” said Matt Dalton, chief executive officer of Rye Brook, New York-based Belle Haven Investments, which oversees $5.7 billion of municipal bonds, including insured Puerto Rico debt. “We know it’s a problem.”

Municipal bankruptcies are rare, given that governments have the power to raise taxes to satisfy their debts. Even after the Great Recession, only a few local governments did so. And the scale of Puerto Rico’s debts is far larger than any other major American government, exceeded only by those of the more populated and wealthier New York, California and Massachusetts.

While some issuers can solve their fiscal challenges over time, investors will be watching states and localities with mounting financial problems, said Robert Amodeo, head of municipals in New York for Western Asset Management Company.

“Each issuer faces different circumstances, and some can fix their imbalances over time, but new negative information will heighten concerns for any one of them,” Amodeo said.

Pension Woes

Puerto Rico’s collapse also shows the pressure than can emerge when retirement systems run out of cash. States such as Illinois and New Jersey are under increasing fiscal strain as their unfunded retirement liabilities grow. The gap between U.S. state pension assets and benefits promised to public employees climbed to $1.1 trillion in 2015, Pew Charitable Trusts said in a report last month.

Illinois is grappling with more than $129 billion of retirement debt, leaving the state with the worst credit rating in the nation. Efforts to shore up its retirement systems have fallen victim to partisan gridlock as Republican Governor Bruce Rauner and the Democrat-led legislature have failed to agree on a spending plan for almost two years.

Even so, the possibility of petitioning Congress to allow for bankruptcy isn’t being discussed, and Democrats have roundly ruled out allowing even the Chicago school district to do so. The idea for opening bankruptcy to states was briefly raised in the Republican-led U.S. House of Representatives after the recession, only to be dismissed by governors who said it would cause investors to demand higher yields on their bonds.

Nobody should assume that a Puerto Rico-type restructuring could be applied to U.S. states: Territories and states are distinct under the U.S. Constitution, and the Tenth Amendment limits the federal government’s ability to legislate for the states, according to lawyers and legal scholars.

Virgin Islands

“If Congress acting under Article I powers were to amend the bankruptcy code to allow either voluntary or involuntary debt adjustment for U.S. states, very serious questions would be raised about unconstitutionality,” wrote Fordham University School of Law Professor Andrew Kent in a April 20, 2016 letter to the congressional committee that drafted Puerto Rico’s oversight law.

The events in Puerto Rico may have more immediate relevance to the U.S. Virgin Islands, its smaller Caribbean neighbor. Debt sold by the island is junk-rated, it faces population decline, large unfunded retirement liabilities and has a history of borrowing to fill budget gaps.

“If Puerto Rico can achieve this level of debt relief through Promesa as the initial plan suggested, it will only make sense for Virgin Islands to attempt the same,” said Matt Fabian, a partner with Municipal Market Analytics.

(Adds comment from former adviser in the fourth paragraph.)

--With assistance from Elizabeth Campbell

©2017 Bloomberg L.P.

Puerto Rico declares bankruptcy. Here's how it's going to unfold

Facing mountainous debt and population loss, the board overseeing Puerto Rico filed Wednesday for the equivalent of bankruptcy protection in a historic move that's sure to trigger a fierce legal battle with the fate of the island's citizens, creditors and workers at stake.

The oversight board appointed to lead the U.S. territory back to fiscal sustainability declared in a court filing that it is "unable to provide its citizens effective services," crushed by $74 billion in debts and $49 billion in pension liabilities.

The filing casts a shadow of uncertainty over the future of Puerto Rico pensioners, American retirees who own the island's debt, institutional investors who backed the island in good times and businesses with lucrative contracts.

But it could also provide hope to residents seeking to preserve access to basic services such as public safety and health care, while also offering a potential route to economic stability for an island that has been suffering for years. Puerto Rico officials have complained that their debt crisis has cut off funds needed to pay doctors and run schools.

Puerto Rico has lost 20% of its jobs since 2007 and 10% of its population, sparking an economic crisis that worsens by the day.

The island's response has worsened matters. Politicians raised taxes, allowed governmental bureaucracy to balloon, borrowed to pay the bills and promised pensions that the island could not afford.

"The result is that Puerto Rico can no longer fully pay its debt and pay for government services," the oversight board said in the court filing. "Nor can Puerto Rico refinance its debt — it no longer has access to the capital markets. In short, Puerto Rico’s crisis has reached a breaking point."

The island's slumping economy was, perhaps, the final straw. Some six in 10 Puerto Ricans are unemployed or not interested in working, and nearly half are enrolled in Medicaid.

Puerto Ricans are U.S. citizens and can move to the mainland at any time, draining the island's tax base. Tens of thousands have streamed into Florida.

The legal case is not technically considered a bankruptcy filing under the federal code that governs municipal cases, but it's similar. Instead, it was filed through a bankruptcy-like mechanism dubbed Title III of legislation authorized by Congress and signed into law by President Obama in 2016.

Here are key questions:

What happens next?

U.S. Supreme Court Chief Justice John Roberts will appoint a life-tenured judge, likely a U.S. District Court judge, to oversee the case, said Melissa Jacoby, a University of North Carolina law professor and expert on municipal bankruptcy.

That's different than Chapter 9 municipal bankruptcy cases, where a bankruptcy judge controls the process.

The person appointed to oversee the case will have significant power over how it unfolds.

This particular debt-cutting process has never occurred, so the lack of legal precedent could leave the judge with much sway over the future of Puerto Rico.

What does the oversight board do?

The oversight board will aim to negotiate debt cuts with creditors, after which it will propose a plan of adjustment. The judge will decide whether to authorize the plan, which could lead to massive debt cuts.

How will investors be treated?

They're in trouble.

To be sure, it depends on the status of their debt. If they hold secured bonds, they might get paid in full. But unsecured bondholders could suffer significant cuts, depending on which types of debt the judge determines to be vulnerable.

Financial creditors, including major investors that had bet on Puerto Rico bonds that were exempt from federal, state and local taxes, argue that their investments were made when the island was not eligible for bankruptcy.

But Congress passed the Puerto Rico Oversight, Management and Economic Stability Act (PROMESA) specifically to create a process that allows the island's numerous debt-saddled governmental entities to achieve debt relief.

Complicating matters is the various governmental entities included in the bankruptcy filing, each of which has its own investors and creditors wanting to be paid.

"It really isn’t clear how creditors stack up against each other," Jacoby said.

Moody's Investor Service Vice President Ted Hampton concluded Wednesday that the bankruptcy filing is actually "a positive step for bondholders overall" because it will bring about "orderly process that should be better for creditors in the aggregate than a chaotic and uncertain period involving proliferating lawsuits."

What happens to Puerto Rico pensioners?

They might face cuts because Puerto Rico has run out of pension funds.

In the Chapter 9 bankruptcy of Detroit, retirees agreed to accept cuts after a federal judge ruled that their pensions could be cut in municipal bankruptcy. That could pave the way for a similar ruling in Puerto Rico.

The PROMESA law states that the oversight board must identify a fiscal plan that will "provide adequate funding for public pension systems."

Puerto Rico pensioners also have certain legal protections, but inside of bankruptcy those protections can collapse. That's exactly what happened in Detroit.

That's why pension cuts and reductions to health care insurance could be in the cards.

But pensioners may still fare better than investors, Municipal Market Analytics analyst Matt Fabian suggested Tuesday in a research note. That's because pensioners are more politically empathetic than Wall Street creditors and bond insurers.

Could Puerto Rico sell off assets to pay some debts?

That's possible. In Detroit, which had $18 billion in debt, the city faced pressure from creditors and pensioners to consider selling off the city-owned Detroit Institute of Arts. The city instead negotiated a deal to avoid liquidating art and collected an infusion of cash from private donors and the state of Michigan.

The city could not be forced to sell assets because Chapter 9 bankruptcy prevents federal judges from ordering municipalities to take such actions.

Similarly, PROMESA dictates that the court may not "interfere with" the island's "property or revenues," without the oversight board's consent.

So a judge may not be able to order the island to sell off beachfront property.

But that doesn't mean creditors won't try to pressure the island into it.

"I wouldn’t be surprised because we’ve seen it in other contexts," Jacoby said.

© 2017 USATODAY.COM

Stakes are high in Puerto Rico’s ‘bankruptcy’

Ripples will extend far beyond its shores

“Puerto Rico can no longer fully pay its debt and pay for government services.” Oversight board

Facing mountainous debt and population loss, the board overseeing Puerto Rico filed Wednesday for the equivalent of bankruptcy protection in a historic move that’s sure to trigger a fierce legal battle with the fate of the island’s citizens, creditors and workers at stake.

THAIS LLORCA, EUROPEAN PRESSPHOTO AGENCY People face off with police during a strike against austerity measures, in San Juan, Puerto Rico, on Monday.

The oversight board appointed to lead the U.S. territory back to fiscal sustainability declared in a court filing that it is “unable to provide its citizens effective services,” crushed by $74 billion in debts and $49 billion in pension liabilities.

The filing casts a shadow of uncertainty over the future of Puerto Rico pensioners, American retirees who own the island’s debt, institutional investors who backed the island in good times and businesses with lucrative contracts.

Puerto Ricans are U.S. citizens and can move to the mainland at any time, draining the island’s tax base. Tens of thousands have streamed into Florida.

Wednesday’s actions also could also provide hope to residents seeking to preserve access to basic services such as public safety and health care, while also offering a potential route to economic stability for an island that has been suffering for years. Puerto Rico officials have complained that their debt crisis has cut off funds needed to pay doctors and run schools.

Puerto Rico has lost 20% of its jobs since 2007 and 10% of its population, sparking an economic crisis that worsens by the day.

The island’s response has worsened matters. Politicians raised taxes, allowed governmental bureaucracy to balloon, borrowed to pay the bills and promised pensions that the island could not afford.

“The result is that Puerto Rico can no longer fully pay its debt and pay for government services,” the oversight board said in the court filing. “Nor can Puerto Rico refinance its debt — it no longer has access to the capital markets. In short, Puerto Rico’s crisis has reached a breaking point.”

The island’s slumping economy was, perhaps, the final straw. Some six in 10 Puerto Ricans are unemployed or not interested in working, and nearly half are enrolled in Medicaid.

The legal case is not technically considered a bankruptcy filing under the federal code that governs municipal cases, but it’s similar.

Instead, it was filed through a bankruptcy-like mechanism dubbed Title III of legislation authorized by Congress and signed into law by President Obama in 2016.

Here are key questions:

WHAT HAPPENS NEXT?

U.S. Supreme Court Chief Justice John Roberts will appoint a lifetenured judge, probably a U.S. District Court judge, to oversee the case, said Melissa Jacoby, a University of North Carolina law professor and expert on municipal bankruptcy.

That’s different than Chapter 9 municipal bankruptcy cases, where a bankruptcy judge controls the process.

WHAT DOES THE OVERSIGHT BOARD DO?

The oversight board will try to negotiate debt cuts with creditors, after which it will propose a plan of adjustment. The judge will decide whether to authorize the plan, which could lead to massive debt cuts.

HOW WILL INVESTORS BE TREATED?

They’re in trouble.

It depends on the status of their debt.

If they hold secured bonds, they might get paid in full. Unsecured bondholders could suffer significant cuts, depending on which types of debt the judge determines to be vulnerable.

Financial creditors, including major investors that had bet on Puerto Rico bonds that were exempt from federal, state and local taxes, argue that their investments were made when the island was not eligible for bankruptcy.

WHAT HAPPENS TO PUERTO RICO PENSIONERS?

They might face cuts because Puerto Rico has run out of pension funds.

In the Chapter 9 bankruptcy of Detroit, retirees agreed to accept cuts after a federal judge ruled that their pensions could be cut in municipal bankruptcy. That could pave the way for a similar ruling in Puerto Rico.

Pensioners may still fare better than investors, Municipal Market Analytics analyst Matt Fabian suggested Tuesday in a research note. That’s because pensioners are more politically empathetic than creditors and bond insurers.

Bond Market Unlikely to React Strongly to Tax Plan: Analysts

By Allyson Versprille

President Donald Trump’s tax plan is unlikely to trigger a frenzied municipal bond sell-off even if it includes provisions that negatively impact the exempt bond market, analysts told Bloomberg BNA.

Conflicting messages on tax reform from high-level officials in Trump’s administration have desensitized the market, Citigroup Inc. analysts Vikram Rai, Jack Muller and Loretta Bu said in an April 24 note to clients. “Now investors seem to shrug off statements from the administration regarding tax-reform” though they haven’t completely discounted that an overhaul could happen eventually, they said.

Rai told Bloomberg BNA April 25 that investors have begun to realize how difficult it will be to overhaul the tax code, especially with such a divided Congress. “I don’t think we’ll see a very sharp reaction from the bond market or the municipal market,” he said. The opposite would have likely been true had Trump’s tax plan been unveiled six months ago, Rai said.

LEARN MORE

Also available on Bloomberg BNA Tax & Accounting

Built on the foundation of the Tax Management Portfolios™, Bloomberg BNA Tax & Accounting is a comprehensive tax research solution designed by tax practitioners for tax practitioners. An easy-to-use interface and improved search deliver the fastest and easiest access to the expert analysis, in-depth news, extensive primary source material, and full range of practitioner-developed tools only available from Bloomberg BNA.

Trump is scheduled to release his plan April 26, but it will provide only an outline of a more detailed plan expected in June.

Matt Fabian, a partner at Municipal Market Analytics Inc., agreed that the plan is unlikely to cause huge waves in the municipal bond market.

Achieving comprehensive tax reform before year-end seems less plausible than it did immediately after Trump was elected, he said. There haven’t been any congressional hearings on potential tax reform provisions and no bills have been introduced, Fabian said.

November Sell-Off

Even if some investors sell off their municipal bonds as a result of Trump’s tax announcement, history shows that these types of reactions aren’t always lasting.

“The municipal bond market reacted strongly in November in the aftermath of the election as investors pulled money from the sector, causing yields to rise significantly relative to Treasuries,” Benjamin Streed, a fixed-income strategist at Raymond James Financial Inc., said in an April 25 email. But this sell-off reversed over the last few months, he said.

“The data indicate that investors appear more comfortable with short and intermediate maturities, but overall the initial sell-off might’ve been a bit overdone,” Streed said.

Recent strength in the municipal market may indicate that, while investors seem to know tax reform is still on the docket, they expect the overhaul to be less extreme than initially thought, he said.

For example, during the week ending April 12 municipal bond funds saw inflows of $1.63 billion, according to Thomson Reuters Lipper, Streed said. “This marks the third largest inflow on record and most since 2009,” he said. And “although we haven’t undone the outflows since the election, muni markets are recovering as investors continue to seek out high-quality, income producing, tax-exempt assets.”

Potential Tax Provisions

Expectations of the tax plan are for a “bird’s eye view,” Streed said. “Investors care about specifics. Those specifics, whenever they arrive, will be critical. At this juncture there are likely to be many unknowns in the plan.”

One provision the Trump plan is expected to include is a 15 percent corporate tax rate, which could be an especially divisive issue among lawmakers, Rai said. The deficit hawks in the Republican party “understand that a lower corporate tax rate will increase the cost of tax reform because every 1 percent cut to the corporate tax rate costs the federal government $100 billion” over a decade, he said.

A 15 percent corporate rate would also negatively impact the municipal bond market, if enacted.

Banks and insurance companies are the primary crossover buyers of municipal bonds, Fabian said. Cutting the corporate tax rate to 15 percent would reduce the value of a municipal bond’s tax exemption and the after-tax benefit to those companies, he said.

At the beginning of the tax reform discussions, issuers were concerned that municipal bonds could lose their exemption in order to pay for other parts of the tax plan, but those fears have subsided, the analysts said.

“The risk of tax reform damaging the exemption is relatively low,” Fabian said. “But if we’re wrong, then the potential correction would be harsher because most of the market is expecting the same thing to happen.”

‘Moderate’ Negative Effects

Fabian said while he doesn’t anticipate that the municipal bond market will react strongly to the Trump tax plan, there could be “moderate” negative effects.

“I think it’ll tend to trend negative because investors who have put their money into equities in the belief that tax reform is going to happen are going to be consoled by the president talking more directly about tax reform,” he said.

It will perpetuate the “risk-on” trend—meaning investors engage in higher-risk investments like stocks—that started when Trump took office.

As a result, Treasury bond prices could fall and “munis will tag along” because they trade closely with respect to Treasuries, Fabian said.

Additionally, talks of a tax plan that isn’t deficit-neutral could be a red flag to muni investors. Increasing the deficit would prompt the government to issue more Treasuries in the long term to generate revenue—increasing supply and reducing demand. Adding to the deficit could also jeopardize the U.S. credit rating, he said.

To contact the reporter on this story: Allyson Versprille in Washington at aversprille@bna.com

To contact the editor responsible for this story: Meg Shreve at mshreve@bna.com

For More Information

The Citigroup client note is at http://src.bna.com/ofs.

Hedge Funds That Flocked to Puerto Rico Bonds Face Long Road Out

Michelle KaskeApr 24, 2017 9:20 am ET

(Bloomberg) -- Hedge funds first starting buying Puerto Rico debt in the summer of 2013 because they liked what they saw: A government that was paying high, tax-free yields that couldn’t go bankrupt.

Nearly four years later, the Caribbean island has defaulted on most of its bonds and Governor Ricardo Rossello, who took office in January, says it can pay less than a quarter of what’s owed over the next decade, assuming he can slash the budget and increase the island’s revenue. Some of the securities are trading near record lows. And, thanks to the U.S. Congress, Puerto Rico and its federal overseers can use bankruptcy-like proceedings to have some of its $70 billion debt written off in court, something investors once assumed it couldn’t ever do.

“It’s been a really long trade,” said David Tawil, president and co-founder of Maglan Capital LP, who bought Puerto Rico bonds in 2013 but has since sold them. “I don’t think when they first got into this they bargained for this type of length of trade. There’s been a lot more twists and turns and not to any substantial progress point between then and now.”

Puerto Rico investors holding general-obligation bonds and sales-tax debt and insurance companies are negotiating through mediation on a restructuring deal, the largest ever in the $3.8 trillion municipal-bond market. There isn’t much time: The commonwealth faces a fresh hurdle on May 1, when a temporary hold that’s sheltered it from the impact of creditor lawsuits is set to expire. If Puerto Rico fails to strike a deal with its creditors or gets bogged down in a legal morass, it can seek to reduce its obligations through a court -- an avenue that analysts say looks increasingly likely.

“We’re at the very beginning of a process that will likely take years,” said Matt Fabian, partner at Concord, Massachusetts-based Municipal Market Analytics Inc.
 

Hedge funds, which hold about one-third of Puerto Rico’s debt, started buying in 2013, after the island’s long-running recession and unremitting budget shortfalls caused other investors to flee. The distressed-debt buyers scooped up the bonds as traditional municipal-bond investors dumped their holdings and prices fell. An index of Puerto Rico bonds plunged nearly 10 percent in August 2013, the biggest monthly decline since the index’s inception in 1999.

The size of Puerto Rico’s outstanding debt made it easy to take large positions and the discounted value left open the chance of a price rebound -- dangling an opportunity for speculative gains rarely seen in the municipal market, where few borrowers default. Distressed debt was scarce at that time and the island’s bonds were one of the few places to buy cheap securities, Tawil said.

“This was the first real distressed opportunity in U.S. municipals,” Tawil said. “It’s a gigantic capital structure so all of the big distressed guys can go ahead and look at this and say ‘I could put a couple hundred million to work here, no problem.”’

Hedge funds wagered that investors would ultimately allow the island to push out maturities if the commonwealth did its part to cut the government’s spending, Tawil said. Instead, by 2015, Puerto Rico started defaulting on bonds to avoid potentially devastating budget cuts.

“There’s just not enough money,” Fabian said. “We have a basic problem of where do municipal-bond payments fit as far as the priority of payment? GO and Cofina believe that they’re at the top and the board believes they’re at the bottom.”

While Puerto Rico’s debts include a web of obligations sold by different government entities with various repayment pledges, investors are now fighting over an average $787 million that Rossello says he has each year to pay principal and interest over the next decade. One key issue is what will receive a better recovery -- the $12.5 billion of general obligations or the $17.3 billion of sales-tax bonds.

Puerto Rico’s constitution states the island’s general obligations are to be paid before other expenses, while sales-tax bonds have a claim on that revenue before the commonwealth can use it for other expenses. The government hasn’t missed payments on its sales-tax bonds.

Moody’s Investors Service estimates the general obligations and senior Cofinas, which get first claim on the sales-tax receipts, will receive 65 cents to 80 cents on the dollar in a restructuring deal. MMA’s Fabian doubts the recovery rates will be that high because Puerto Rico’s outcome is unpredictable. Securities with even weaker repayment pledges may receive less than 10 cents on the dollar, he said.

Some bonds are trading below the projected recovery rates. General obligations with an 8 percent coupon and maturing in 2035, the island’s most-actively traded, fell to as little as an average 61.8 cents on the dollar on March 30, the lowest since they were first sold in 2014 at 93 cents, data compiled by Bloomberg show. The debt traded at an average 63.1 cents on Friday.

Cofinas with 6.05 percent coupon and maturing in 2036 traded at an average 60.8 cents Friday after falling to 58.7 cents on April 12, the lowest in nearly a year, Bloomberg data show.

Analysts say Puerto Rico’s debt crisis will ultimately be resolved in court, given the long odds of convincing creditors -- some of whom have already taken opposing sides in lawsuits -- to voluntarily accept steep losses, despite whatever legal claims they have on the government’s cash.

“It’s hard to see how mediation could succeed theoretically,” Fabian said. “There are fundamental points like the constitutional prioritization of GOs and the purported segregation of Cofina that need a court to decide their staying power.”

The Week in Public Finance: Ballmer's Data Trove, Grading Pension Health and a New Muni Bond Threat

This Goes Way Beyond Open Data

You might not peg former Microsoft CEO and current owner of the NBA’s Los Angeles Clippers as a government data geek. But Steven Ballmer stepped into that role in a grand scale this week when he unveiled his privately funded, years-long project to help citizens easily track how government spends their money.

Called USAFacts, the website contains federal, state and local aggregated data on revenue and spending, as well as on debt, population, employment and pensions. Want to know about pension debt? Two quick searches reveal that unfunded liabilities in state and local retirement systems have more than quadrupled since 2000. At the same time, the median age in the country has increased by 2.5 years.

As a businessman used to the corporate world, Ballmer wants to make government financial reports more readable. To that end, the site has introduced the first government "10-K report" -- the private sector's version of an annual financial report. It aggregates data from all U.S. governments and gives progress reports on government programs, provides financial balance sheets and gives data on key economic indicators.

The Takeaway: Ballmer says USAFacts is not meant to insinuate that governments should be more like businesses. But the creation of this data trove does speak to a growing desire among the business community and citizens for better access to uniform financial data. No two governments are alike in how they present and deliver their financial data, to say nothing of the amount of time in which it takes them to do so. That makes any data compilation incredibly burdensome. Now, at least on a national basis, that headache has been eliminated.

What's more, shining a light on the real numbers behind government has the potential to change peoples’ assumptions about it. By way of explanation, Ballmer looked up how many people work for government in the U.S. The answer: nearly 24 million. When people hear that, they tend to say, "‘Those damn bureaucrats!’” he told The New York Times. But a look at the data may elicit a different response. Almost half are educators. Active-duty military and health workers represent huge blocks as well. Now, "your tax dollars are helping somehow to pay 24 million people -- and most of these people you like,” Ballmer said.

Diverging Pension Paths

A new report  this week from the Pew Charitable Trusts shows that while a number of public pension plans took positive steps toward solvency, their total unfunded liabilities still increased in each of the last two years. It also found that in 2015, more than half of states achieved what’s called positive “net amortization.”

The metric, introduced by Pew  last year, essentially measures whether a state is on a path to eventually eliminate its unfunded pension liabilities. The measurement does this by looking at whether a pension plan’s accounting assumptions -- notably its assumed investment earnings -- and payment schedule will hold up over time. In 2014, just 15 states achieved positive amortization. The following year, 32 did.

Despite this improvement, unfunded liabilities increased to $1.1 trillion in 2015 and are expected to total $1.3 trillion when data from 2016 is complete. The more than $350 billion increase over two years is largely due to lower-than-expected investment earnings. However, the report notes that roughly $8 billion of the shortfall is due to plans not paying their full pension bill.

The Takeaway: While it’s good that more plans shifted into the positive, there are still things to be wary about. Namely that the shift could be short-lived: There are still legitimate concerns that pension plans won’t meet their assumed rates of investment return. “Obviously you don’t know what the future will hold,” David Draine, a senior researcher, told reporters, “so the question is, are policies in place sufficient to address the uncertainty?”

For 18 states, Pew’s report says the answer to that question is a resounding no. These states have negative net amortization, meaning their liabilities will continue to increase unless they change their funding habits and/or assumptions. These states include Colorado, Illinois, Kentucky, New Jersey and Pennsylvania, which fared worst on this benchmark in 2015.

Muni Tax Exemption Threat Not Over Yet

The tax-exempt status of muni bonds might not be as safe under the current administration as some have thought. Several municipal analysts have been warning that the exemption, which allows muni bond investors to earn tax-free interest on their bonds, could be threatened by tax cuts that disproportionately benefit the wealthy.

In particular, President Trump has proposed major cuts in taxes on investment earnings. Compared to corporate bonds, municipal bonds earn slightly lower interest rates for investors because of their tax-free perk. But Court Street Group analyst George Friedlander has said a significantly lower tax rate capital gains might negate that perk -- and see investors turn more towards taxable debt for the higher investment earnings.

That lower demand for munis would drive up their interest rates and make it more expensive for governments to issue bonds. That introduces the possibility that reformers would argue the exemption therefore doesn't make much of a difference in goverments' borrowing costs. This could be the ammo some need to nix the perk entirely. That, noted Municipal Market Analytics’ Tom Doe this week, could be a boon for public-private-partnerships (P3s), “under the guise of efficiency, savings and jobs for the middle class.”

The Takeaway: Businesses have advocated that P3s offer better procurement, less risk for governments and are an ultimately cheaper way to deliver new infrastructure. But they haven’t taken off in the U.S. primarily because the municipal market offers such relatively inexpensive financing for governments. By comparison, Europe has no municipal market equivalent and P3s are the primary financing mechanism for major projects.

A key player in all this might be the role of Gary Cohn, director of the National Economic Council and a former Goldman Sachs president. As President Trump reshuffles key staff, Doe notes that Cohn, a Democrat, may soon ascend to Trump’s chief of staff. Democrats have supported limiting the tax exemption because it is largely seen as a perk for the wealthy, who are the primary investors in muni bonds. In addition, a Democrat could be more effective in whipping up bipartisan support to push through tax reform. “Trump wants wins now,” Doe wrote, “and Cohn may simply be the guy to deliver.”

Illinois Morass Fuels Speculation It'll Be First Junk-Bond State

• Gridlocked state headed to third year without a budget

• Rating companies warn of further downgrades without a solution

What’s worse than the worst? Illinois may find out.

The lowest-rated U.S. state is headed toward its third year of an unprecedented budget impasse as Republican Governor Bruce Rauner and the Democrat-led legislature repeatedly fail to agree on how to plug chronic deficits and halt the growing backlog of unpaid bills.

Both Moody’s Investors Service and S&P Global Ratings have warned that Illinois could be downgraded again, while investors are already demanding higher yields on its bonds than they do from borrowers that are on the cusp of junk, according to data compiled by Bloomberg.

“It’s getting harder and harder to find a reason to be optimistic for a budget,” said Ty Schoback, a senior analyst in Minneapolis at Columbia Threadneedle Investments LLC, which holds some Illinois debt among its $22 billion of municipal holdings. “That being said, this is politics -- you can’t predict. Two years ago, we were debating whether or not Illinois falls into BBB. Today, we’re debating whether it falls to junk status. If the status quo persists, what are we going to be debating in two years?”

The standoff has wreaked havoc on the fifth-most-populous state’s finances and sunk its credit rating. Unpaid bills have soared to a record $13 billion, and entities that rely on state aid, including public universities, have had to furlough workers and cut services. A stopgap budget expired in December and a bipartisan package of tax increases and spending cuts aimed at ending the standoff fizzled in March. Illinois’s leaders are at a "critical juncture,” according to Moody’s.

“Governor Rauner is optimistic that a balanced budget will be passed soon that will contain reforms to protect taxpayers and recruit new businesses that will boost the economy and create jobs across Illinois,” Eleni Demertzis, a spokeswoman for Rauner, said in an e-mailed statement. 

If an agreement isn’t reached by the end of May, when the regular legislative session ends, a three-fifths majority will be required to pass anything, making a compromise even harder to reach.

Both Moody’s and S&P have warned of further credit deterioration if Illinois enters a third year without a spending plan. Both companies rank Illinois only two steps above junk with negative outlooks, signaling the rating could fall again. No U.S. state general-obligation bonds have ever been rated below investment-grade, according to data going back to at least 1970.

Investors have to be prepared for the possibility, said Matt Fabian, a partner with Municipal Market Analytics Inc.

Illinois is “being managed as if it were a speculative credit,” Fabian said. “It’s hard to get on board and say that Illinois is a buy for anyone besides speculative investors.”

Investors already demand higher yields to hold debt issued by Illinois. The state’s 10-year yields have climbed to 4.3 percent, or about 2.2 percentage points more than benchmark tax-exempt debt, according to Bloomberg’s indexes. That’s the most of all 20 states tracked by Bloomberg and more than investors recently demanded on debt issued by borrowers with the lowest investment-grade ratings.

“Barring a comprehensive solution and a budget in place and some real concession on both sides, I think there’s always room for spreads to widen,” said Adam Buchanan, senior vice president of sales and trading at Ziegler, a broker-dealer in Chicago. “There is certainly room for more deterioration in their levels.”

No U.S. state has defaulted on its debt since the Great Depression, and no one is expecting that from Illinois anytime soon. Illinois has been making monthly deposits to its debt service funds for its general-obligation and sales tax-backed bonds, despite the lack of a budget, according to Moody’s. But without a compromise by the end of May, there’s a risk of "creditor-adverse actions” like borrowing from debt-service funds, or "eventually, prioritizing core operating needs over debt service,” according to Moody’s.

Losing its investment-grade rating would make borrowing more expensive and limit the pool of buyers for Illinois debt, further complicating efforts to ease the liquidity crisis. The compromise that lost traction in March included a plan to issue as much as $7 billion of bonds to pay overdue bills.

The state has time to stabilize its finances. The next fiscal year begins July 1. If the two sides are able to come together operating liquidity can get restored quickly, according to Moody’s. The state has the capacity to raise taxes. Its income tax rate is 3.75 percent, after a temporary hike to 5 percent expired in January 2015.

Rauner and Democrats can’t agree on how to fill the hole from that lost revenue even as the state continues to spend money through a combination of continuing appropriation bills, court orders and consent decrees. Rauner, who took office in January 2015 as the first Republican to lead the state since 2003, wants any spending plan to be linked to parts of his agenda, like property-tax limits or changes in workers-compensation laws, which Democrats have resisted.

“They still have the ability to make changes should they desire to do so,” said Eric Friedland, director of municipal research in Jersey City, New Jersey, for Lord Abbett, which manages about $20 billion of municipal debt, including some Illinois holdings. “But the longer this goes, the more difficult it is for them to put themselves on a good course.”

Bullet Train From L.A. to San Francisco Gets State Funding Despite Trump Opposition

So much for a big federal infrastructure initiative. The Trump administration has blocked funding for California’s bullet train so the state is selling bonds to fund the high-speed train from San Francisco to Los Angeles on its own. — Dennis Schaal

California isn’t letting litigation or Donald Trump stand in the way of one of the most expensive and controversial projects in the U.S.

The state on Thursday plans to sell $1.25 billion in taxable bonds to finance a $64 billion high-speed rail system, the first debt issue for construction since voters approved it nearly a decade ago. The offering marks a show of faith from officials that the project will proceed despite a lawsuit from a county and farmer opposed to it and roadblocks from the Trump administration, which has delayed a grant that would have benefited the bullet train running from San Francisco to the Los Angeles area.

The general-obligation debt, backed by California’s full faith and credit, isn’t dependent on the success of the project, the first publicly financed U.S. high-speed rail line. Lack of federal support would push more of the burden on California to finance the project, which Democratic Governor Jerry Brown says will transform the traffic-choked state by increasing access to affordable housing and boosting local economies.

“California can well afford it, and it will make our state a much better place,” he said in February in a recorded news conference to which his press office referred in response to questions. “I know we’re going up against a very red tide here of opposition. This thing is a long-term project, and one way or another we’re going to get it.”

It’s a good time for California to borrow, with its bond ratings their highest since the turn of the century since it turned a spate of deficits into surpluses. The state’s 10-year tax-exempt securities yield about 2.3 percent, or 0.24 percentage point more than benchmark debt, less than half the premium it paid three years ago, data compiled by Bloomberg show. Boosting the bond sale is the “state brand’s surging value,” said research firm Municipal Market Analytics.

After years of delay, due partly to legal challenges, construction is already underway on 119 miles of track in the Central Valley. By 2029, if work goes as planned, passengers will be able to travel at speeds of more than 200 miles an hour between San Francisco and Anaheim, south of Los Angeles, according to the California High-Speed Rail Authority.

Voters in 2008 approved almost $10 billion of general obligations for the project, and of that, about $1 billion has been sold to finance costs such as design and environmental reviews, according to the state treasurer’s office. So far, work has cost about $3 billion, with about $2.35 billion coming from the federal government.

On April 26, opponents of the project will ask a Sacramento County Superior Court to block the state from using proceeds from the bond sale for it. A victory for the opponents could lead federal officials to demand that the state pay back money it has so far received, according to bond documents circulated to investors.

Another risk: future federal grants may not roll in. The high-speed rail authority’s most recent business plan in May 2016 said it plans to seek additional funds from Washington, without specifying the amounts.

Already, a $647 million federal grant slated for the electrification of another commuter rail line, which is also needed for the high-speed system, was been suspended by Trump’s administration after California’s House Republicans asked for it to be withheld.

One of them was U.S. Representative Jeff Denham, from the Central Valley, who said he doubts the project will get additional federal dollars until there’s a full explanation of all funding sources and costs.

“If you’re going to continue to obligate state dollars that you do not have, then you’re in jeopardy of at some point the federal government calling for those notes to be due, which could then put public safety dollars at risk, other transportation dollars at risk or education dollars at risk,” said Denham, who sits on the transportation and infrastructure committee.

Under the measure approved by voters, California’s department of finance must review the funding plan for each segment of the rail before permitting the use of bond funds. It did so in March, saying that for the $7.8 billion Central Valley portion, the risks “are more limited because the bulk of funding is nearly in hand, and much work has already been completed.”

A study previously commissioned by the U.S Treasury Department under then-President Barack Obama listed the project as among 40 with major economic significance that were at risk of not coming to fruition. Under an assumption that the costs totaled $59 billion, it pegged the net economic benefits at at least $130 billion.

“There are a lot of federal questions,” said Howard Cure, head of municipal research in New York at Evercore Wealth Management. “When you don’t have the Republican contingent from your state pushing for it, it is potentially a big problem.”

Emanuel's short-term budget solutions will cost $1 billion in interest

For years, Chicago has patched up budget deficits with long-term borrowing — an expensive habit that Mayor Rahm Emanuel inherited, perpetuated and has vowed to break.

But a Tribune analysis of the city's latest bond sale, a $1.2 billion offering earlier this year, shows that the mayor will continue to run the city with borrowed money, at great long-term expense, through the rest of his term in 2019.

Among the findings of that analysis:

•The majority of the money will be used for budget relief and come at a very high cost. Almost all of the additional costs, however, do not kick in until after the end of Emanuel's current four-year term. By paying only interest for the first several years of the loan, Emanuel can use the funds borrowed this year to smooth out budgets through 2019 at minimal expense.

•Some of the money will be used to refinance previous borrowing but at a higher interest rate. The main advantage for the city is that it kicks the costs further into the future. In all, taxpayers are on the hook for $1.1 billion in interest on the loan, which will cost $2.3 billion to repay over 20 years.

•The city will continue to rely on borrowed money to pay legal settlements, turning to a new stockpiling strategy rather than trying to pay these costs out of its regular operating revenues as many municipalities do. Borrowing this way adds $120 million in interest costs to the $225 million set aside for settlements.

The city portrays the new $1.2 billion in borrowing as a turning point, saying it will no longer restructure old debt to push costs into the future at greater expense. That tactic, known as "scoop and toss," has been widely criticized as a desperation move during the terms of Emanuel and his predecessor, Mayor Richard M. Daley.

In early 2017 the city borrowed $1.2 billion by selling long-term bonds. Chicago will pay $1.1 billion in interest on the deal over the next 20 years.

In early 2017 the city borrowed $1.2 billion by selling long-term bonds. Chicago will pay $1.1 billion in interest on the deal over the next 20 years.

See more videos

City Budget Director Alexandra Holt told the Tribune: "It is the last time we are borrowing for scoop and toss. It is the last time we are borrowing for routine settlements and judgments."

The Tribune detailed Daley's reliance on debt in its 2013 investigative series "Broken Bonds," which showed how the mayor built his political legacy through spending then left taxpayers with a huge debt to pay. The city's massive liabilities, which also include unpaid pension obligations, have driven down the city's credit rating and made it much more expensive to borrow money. Chicago's general obligation bond ratings fell below investment grade in 2015 and remain at junk status.

Open link

Carole Brown, the city's chief financial officer, said January's bond sale is intended to show investors and municipal market analysts action on Emanuel's financial reform agenda. The mayor recently urged Moody's Investors Service to reconsider its low opinion of Chicago's creditworthiness or withdraw its public ratings of the city, arguing in a December letter that the city is on a path to financial stability.

But experts say that, given Chicago's history of borrowing, pension burden and continued struggles to balance its budgets, there can be no certainty the city can make good on promises to end its bad habits.

Matt Fabian, a partner at Concord, Mass.-based Municipal Market Analytics, said he is not convinced that the city has its budget problems solved and that it won't need to scoop and toss old bonds or borrow for judgments and settlements in the future to make ends meet.

"That is the promise from the mayor, and you can't fully dismiss that promise, but as an investor you have to assume they will do this again." Fabian said.

"We all know that the city does not have any extra money, so it makes sense that they would finance what they are going to do," Fabian added, "but this is a cost of the city not having liquid resources elsewhere. This is an example of in America why poor people fall farther behind, because they are forced to finance things that other people would just pay for."

By using bond funds to close its budget gaps, the city can spare residents from further tax increases and avoid more painful cuts to city services in the short term, said Jason Horwitz, the Chicago-based director of public policy and economic analysis for Anderson Economic Group.

But Horwitz said the tactic comes at a high price and essentially guarantees future budget deficits or tax increases, as debt payments pile up for years to come.

"Borrowing more and accumulating more debt has been an expensive choice," he said. "I think the fact the city has drawn out its fiscal problems has made it much more difficult to find remedies."

Of the $1.2 billion the city borrowed, $687 million will go to help close its budget gaps through 2019, including debt payments that are coming due and anticipated legal claims. Just $365 million will go to municipal bonds' more traditional uses — city maintenance, construction and equipment.

Payments on the massive deal are limited to just over $130 million through the next mayoral election. In a particularly complicated move known as "capitalized interest," the city is using $77 million of the borrowed money to pay interest costs on the loan through 2019. That strategy lowers debt costs for several years but increases the amount that must be repaid, adding more than $87 million in interest.

Since Emanuel took office in 2011, the city's general obligation bond liabilities have increased dramatically. The city now owes $18.1 billion in payments on $9.8 billion in debt, up from $13.2 billion on $7.2 billion in 2011.

Debt service on all of Chicago's outstanding general obligation bonds totals $500 million this year, but in 2020 — after the mayoral election — it will grow to more than $900 million. Payments then do not decline significantly until after 2036.

Asked how the city will balance its budgets in those years, budget office spokeswoman Molly Poppe said officials will continue to cut costs through spending reforms and find other available revenues.

Holt said the size and structure of the borrowing was necessary because the city would not be returning to the bond market for several years and needed to be prepared for a variety of costs.

"We need to be prepared to pay for expenses, whether they are fixing bridges or repairing the lakefront or fixing the roofs on buildings or paying judgments and settlements or buying a new fire engine — all of that stuff needs to be paid for, and we do our planning ahead of time," she said.

In a 2015 speech to civic leaders, Emanuel promised that Chicago would begin to pay for more of the city's routine judgments and settlements with operating funds, preserving its long-term debt for the other more common uses of municipal bonds mentioned by Holt.

Indeed, the city plans to use operating funds to pay for all of its 2016 judgments and settlements, which are expected to total roughly $110 million, according to the budget director. That would be the first time since Emanuel took office that no debt would be issued to pay for legal liabilities. According to the city's online financial records, since 2006 the city borrowed to pay a portion of its legal claims every year through 2015.

But this year's bond deal also includes $225 million set aside for future liabilities. In other words, although this could be the last time Chicago borrows money to make these payments, it expects to use borrowed money for that purpose for some years to come — a strategy that adds huge interest costs to each legal claim.

For instance, if the city uses the stockpiled funds to pay $1.8 million in new legal settlements that the City Council approved last month, interest costs would boost the total outlay to $2.8 million, according to the Tribune's analysis.

Including the new bonds, the city has borrowed just under $1 billion for legal costs since 2006, of which $664 million came under Emanuel's watch.

According to Fabian, using some of the borrowed money to stockpile funds to pay for unidentified future liabilities was an expensive and risky budget gimmick that may suggest city leaders fear they may have trouble selling more debt in the future. Brown told the Tribune that the city is not concerned about losing access to the municipal bond market.

Richard Ciccarone, president of the municipal bond research company Merritt Research Services, said the city was being closely watched for progress on the mayor's debt reform agenda, and he was surprised that plan had evolved to borrowing in advance for legal liabilities.

"I think we assumed they would pay off legal liabilities known to them at this time and begin to pay them off going forward with current funds as a pay-as-you-go," Ciccarone said. "The stockpiling for the future might not be the spirit of the way this was understood by many analysts or investors.

"On the positive side, it does provide a contingency for unexpected difficulties that may occur, especially some very highly visible and contentious situations in Chicago both on the law enforcement side as well as the issues involving labor," he said.

The size and scope of Chicago's repeated borrowing to pay for legal claims is extraordinary, according to Ciccarone, who said most cities borrow only occasionally for that purpose — such as when the cost comes unexpectedly or is too large to be paid from available resources.

Ald. Scott Waguespack, 32nd, who sits on the City Council's Finance Committee, said paying more than $100 million in interest to borrow for the city's future judgments and settlements was more than he expected. But specifics about the deal — why the city was borrowing for legal claims, how much it would cost — were hard to obtain from the mayor's finance team, he said.

"They kind of argue that this is what we are going to do, and that is all there is to it," Waguespack said. The bond sale was approved without opposition by the City Council in October.

Brown and Holt said that they spent extensive time briefing the council on the bond issuance and that aldermen were aware of the high cost of the borrowing and how the funds would be used.

Another pledge Emanuel made in his 2015 speech was that the city would end "scoop and toss" refunding by 2019. However, the Tribune found that the latest deal includes refinancing of bonds that would have come due between 2020 and 2022, for a total of just under $50 million in old debt. All of the restructured bonds have higher interest rates and the majority have longer maturities — the hallmarks of scoop-and-toss deals.

Most of that debt — $33 million — would have been paid in 2020. Poppe said the restructuring of those bonds meets the mayor's 2019 deadline because these bonds would have been accounted for in the 2019 budget, despite maturing in 2020.

As for the remaining bonds, she said the debt coming due in 2021 and 2022 is being refinanced using new bonds that will be repaid in the same year as the old bonds, so it is not a scoop and toss. However, the new bonds have a higher interest rate, 7.0 percent compared with 5.6 percent, leading to a small increase in cost.

North Carolina wants to use existing low rates to shore up retiree pensions and health-care debt.

by Liz Farmer | March 8, 2017

In the low interest rate environment, states and localities have been saving billions by refinancing old debt. In most cases, the savings have benefited the general fund balance. But in North Carolina, State Treasurer Dale Folwell is making a push to instead use those savings to pay down pension and retiree health-care debt.

Starting this spring, Folwell plans to refinance “every dollar we possibly can.” He'll ask the General Assembly to divert the savings to the treasurer’s office, where he'll then divvy up the extra dollars: 15 percent goes into the pension fund and 85 percent goes toward retiree health-care debt, which has a larger unfunded liability.

The approach has garnered rave reviews, but some question just how big a dent any such savings can make in an unfunded liability that in North Carolina totals nearly $38 billion between retiree pensions and health care.

RELATED

• Think Public Pensions Can’t Be Cut? Think Again.

• The Week in Public Finance: Detroit's Big Pension Plan, Debating the Pension Crisis and Counties Under the Gun

• Public Pensions and the Assets That Could Sustain Them

• No 401(k)? No Problem. States Have You Covered.

• Buried in College Debt, Minnesotans Get Refinancing Help

It’s true the money can add up. Since 2009, North Carolina has refinanced roughly $4 billion in debt, amounting to savings of nearly $289 million, according to the state’s most recent debt affordability study.

Nationwide, more than half of the total bonds issued in the municipal market since 2009 have been to refinance deals. Last year, roughly $275 billion of the nearly $450 billion in total bond issuance was to refinance existing debt. Refinancing deals are still expected to drive issuance this year, even with the Federal Reserve slated to raise short-term interest rates.

The savings per deal can vary. Connecticut saved nearly $76 million last year when it refinanced $501 million in general obligation bonds. In 2015, Washington state refinanced $421 million and saved $32 million in debt costs.

Municipal bond expert Matt Fabian also notes that savings from refinancing debt aren't immediate. Similar to refinancing a home, the debtor makes lower payments on the debt going forward, meaning the total savings are realized over time. For instance, Connecticut in 2014 refinanced $822 million in general obligation bonds and saved $94.8 million over the next 11 years.“So the savings are real but it’s on paper,” says Fabian, a partner at Municipal Market Analytics. “In effect, it’s a promise to pay [over time] from the general fund the savings they just generated.”

Still, Fabian praises North Carolina because refinancing essentially produces “found” money. “Any time you can start paying down a debt without raising taxes or cutting spending, that’s a good thing,” agrees Donald Boyd, director of fiscal studies at the Nelson A. Rockefeller Institute of Government. He adds that it’s also better fiscal policy to put found money into a one-time use, rather than into recurring expenses like the current year’s budget.

Folwell thinks that credit ratings agencies will look favorably upon the tactic. North Carolina already has a top AAA rating, but he thinks that by urging local governments to follow the state’s lead, it will strengthen their credit ratings as well. “If you take a portion -- if not all – of those interest savings and put it toward another liability,” says Folwell, “it is a win-win in the eyes of the community, the state and the rating agency.”

SEC says cities, states must now disclose bank loans

WASHINGTON -- The Securities and Exchange Commission took a first step toward shedding light on loans from banks to states and localities that are increasingly being used to finance infrastructure projects, rather than issuing debt in public markets.

The SEC on Wednesday unanimously voted to propose new requirements that state and local governments disclose the details of the bank loans, helping to illuminate a corner of the nearly $4 trillion municipal-bond market where there is currently no consistent reporting.

States and localities looking to fund projects such as roads, schools and bridges are turning to bank loans for cheaper financing in recent years. Such loans total roughly $40 billion to $50 billion in annual issuance, according to consulting firm Municipal Market Analytics. Bank loans are cheaper than issuing debt in the public markets in part because they don’t require a rating, which can cost a municipality tens of thousands of dollars, and typically don’t carry the same disclosure requirements.

Investors currently “may have limited access, or substantially delayed access, to information about these nonpublic financings,” SEC commissioner Kara Stein, a Democrat, said ahead of the vote.

The SEC will seek public comment on Wednesday’s proposal for 60 days. After the comment period, the agency would have to vote on the measure before it could go into effect.

Dramatic Slowing in Municipal Defaults So Far this Year

Here's some good news for muni bond investors worry about the impact of Trump administration tax cuts: Municipal bond defaults have slowed dramatically, reports Matt Fabian's Municipal Market Analytics.

In the first six weeks of the year, only six issuers have filed first notices of impairment, he finds, compared to 25 in the first two months last year and 30 the year before.

Fabian writes Friday:

This is a distinct slowing of credit problems that reasonably follows: 1) somewhat stronger economic trends; and 2) materially stronger demand for high yield securities (which permits struggling project debt to be restructured prior to an actual impairment developing). These results are constructive generally for municipals and specifically for continued high yield performance.

The benchmark-tracking iShares National Muni Bond ETF (MUB) rose slightly Friday to $108.30. It is up 0.2% this year

Surging Muni Yields in Chicago Send Warning Signal

Chicago's sale of $900 million general obligation bonds last week came at a high price and has some muni strategists worried about what comes next.

Matt Fabian of Municipal Market Analytics wrote to clients Tuesday:

The deep price concessions made by Chicago to complete its $900M GO sale last week are a point of concern both for the city and for the market at large. Yields near or north of 6.0% represent spreads more than 100bps wider than the city’s last GO sale in January 2016 and are roughly double benchmark 5% AAA nominal yields.

He notes that the city's bonds are trading near Chicago Public Schools, which he thinks is appropriate, but it isn't the way investors typically see things.

The latest pricing has him worried enough that it reminds him of Puerto Rico, circa 2013, when the Commonwealth started to lose access to capital markets. He writes:

The high nominal and relative yield levels draw comparison to PREPA’s beginning-of-the-end 7%’s in 2013, and raise concerns that the city is in the first stages of losing economic market access. MMA does not believe that that has to be the case; however, perceptions of insolvency can be difficult to shake without convincing and sustained positive credit momentum.

City sells $1.16B in bonds, but pays a heavy price for CPS crisis

Chicago sold $1.16 billion in general obligation bonds Thursday, but paid a heavy price for a school financial crisis made worse by Gov. Bruce Rauner’s veto of a bill promising $215 million in pension help.

The “spread” between Chicago’s interest rate and the interest rate the city would have paid if it had a AAA bond rating ranged from 3.3 percent to 3.5 percent, according to Matt Fabian, a partner at Municipal Market Analytics.

Fabian called it the “worst spread” in recent memory on a city bond deal.

Even more surprising was the fact that the interest rate on Chicago’s general obligation bonds was a “full percentage point” higher than it was a year ago — before the City Council approved Mayor Rahm Emanuel’s plan to slap a 29.5 percent tax on water and sewer bills to save the largest of four city employee pension funds.

Market factors beyond the city’s control were working against the city.

The recent interest rate increase and prospects for higher inflation under President-elect Donald Trump meant the “universe of potential players has shrunk,” Fabian said. There’s more yield in “safe” bonds that carry a AA or AAA rating, he said. Fewer investors “need to reach to get the added yield” of a Chicago bond.

But the overriding factor was the financial crisis at the Chicago Public Schools.

“Investors are afraid that CPS might be pulled into bankruptcy in some way or that a new bankruptcy provision might be created or that CPS might have to default on its bonds. And that’s going to directly affect the city,” Fabian said, arguing that the CPS penalty would cost taxpayers millions over the life of the bonds.

There is little doubt that Rauner’s veto of the teacher pension bill “chased away investors and made the universe of buyers smaller,” Fabian said.

“CPS can’t fix its budget problems without the state’s help. And the state, through the governor has shown no interest in providing it,” he said. “Until a plan for CPS materializes, these are the kinds of interest rates the city and the district are gonna have to pay.”

The governor’s veto and the continuing budget stalemate in Springfield were not the only concerns for investors.

So was the $1.16 billion borrowing itself. It includes $440 million in “scoop-and-toss” borrowing, $105 million more than previously planned, that extends for another generation debt that should be retired today.

It also includes $225 million to bankroll settlements and judgments against the city — $100 million more than previously planned.

Emanuel has promised to eliminate both dubious financial practices by 2019. That’s also the deadline he set for eliminating a structural deficit that’s already 80 percent smaller than the one he inherited.

“The fact that this bond sale was still funding scoop and toss and that . . . they’re borrowing to pay interest on the these bonds — those are not the things that healthy cities do,” Fabian said.

“The mayor has made progress. But the city budget is still a mess. . . . The city needs another year or two at least to fully eliminate its budget gap,” he said. “In a few years, if everything else works out, these borrowing costs will begin to come down.”

The Emanuel administration tried to put the best possible face on the transaction, noting that the bonds were “three times over-subscribed” and attracted 145 investors.

“The city continues to address our financial challenges and work to end bad financial practices of the past, and these bonds represent a critical milestone in this effort,” Chief Financial Officer Carole Brown was quoted as saying in an emailed statement.

“This deal represents our final borrowing for scoop and toss, following through on Mayor Emanuel’s commitment to end this practice by 2019. This is also our last borrowing for routine settlements and judgments, continuing the Mayor’s commitment to end the legacy of using long-term debt to pay for operating expenses.”

Moody’s: Bankruptcy, Skipping Pension Payments Options for CPS

The credit rating agency Moody’s Investors Services outlined three “painful” options for how  Chicago and its public school system could get out of money trouble.

The school district could consider another property tax levy to pay off its growing debt or skipping its pension payment to the Chicago Teachers’ Pension Fund, Moody’s says in a pair of reports issued to potential investors Thursday. 

The boldest option was floated as a last resort: Chicago Public Schools should consider seeking state authority to file for bankruptcy. 

Bankruptcy and skipping a pension payment would require changes to state law and bankruptcy has been raised by Gov. Bruce Rauner and Illinois Republicans in the past, but was quickly dismissed by Mayor Rahm Emanuel and others. A spokeswoman for the school district on Thursday said all three options would create more financial problems and would be bad for city taxpayers. 

These reports come one week before the city plans to borrow more money to cover its debt payments and one month after Mayor Rahm Emanuel sent a letter to the credit rating agency accusing it of bias. The city hasn’t requested a credit rating from Moody’s in two years.

Stay up-to-date with the latest news, stories and insider events.

Please enter a valid email address Oops, something went wrong!Sign UpTry Again

You've signed up to receive emails. Please check your email for a welcome confirmation.

“It has become increasingly clear that Moody’s rating methodology and agenda are far from objective and independent,” Emanuel wrote in the December letter. “This is not to say that the City should be rated AAA, but… your current rating does not accurately reflect the City’s credit or our ability to pay debt service when due.”

The report about the City’s finances does acknowledge some of the steps Emanuel has taken to improve both the city’s and the school system’s finances. Specifically, it notes the additional property tax levies that have been created to fund the pensions of city workers, police officers and public school teachers. 

But, the report says, “contributions will remain insufficient to keep reported unfunded liabilities from growing for at least 15 more years.”

The reports issued Thursday are meant to help potential investors decide whether to lend Chicago money.

Matt Fabian, a partner at Municipal Market Analytics, says the city is on the right track, but it’s delicate.

“In general, the city is doing the right things,” Fabian says. “But it’s just started doing the right things. And it’s depending on time to give it more financial flexibility. Maybe it will have that time, and maybe it won’t.” 

He says risks faced by the city and its school system are probably the top two conversations in his professional world.

“The problem with Chicago is not so much the economy, and it’s not even really the pensions, long-term,” he says. “It’s the political issues.”

For instance, raising taxes too quickly could trigger a political backlash, which Moody’s also acknowledges in its report. But going slowly increases the risk that something else — like a recession — could make the financial problems worse.

Dan Weissmann contributed reporting for this story.

Six years after Daley, Emanuel still using high-cost borrowing practices

Mayor Rahm Emanuel is pitching Wall Street investors on the latest city borrowing plan, a $1.2 billion package that, like previous versions, pushes hundreds of millions of dollars of debt into the future at higher costs to taxpayers.

The mayor is continuing scoop-and-toss borrowing, which involves paying off old bonds with the proceeds from new ones — a practice akin to taking out another mortgage on a house to pay off the old mortgage, kicking payments down the road. An Emanuel budget spokeswoman said this year marks the last scoop-and-toss bond issue.

The administration also said it'll be the last time the city will borrow money to pay for a portion of routine legal settlements and judgments, adding millions in interest to what are short-term expenses. Some of that debt will take the form of taxable bonds, which carry higher interest rates. That's because the federal government doesn't allow the issuance of tax-free bonds for what are considered yearly operating expenses.

Kathy Bergen and Stacy St. Clair

Chicago's Washington Park was nearly empty on a recent Friday afternoon as Bronzeville resident Rosemary Jarrett power-walked her usual five laps around the perimeter of the graceful meadowland where a temporary Olympic stadium could have risen this summer.

The school crossing guard shook her head...

Chicago's Washington Park was nearly empty on a recent Friday afternoon as Bronzeville resident Rosemary Jarrett power-walked her usual five laps around the perimeter of the graceful meadowland where a temporary Olympic stadium could have risen this summer.

The school crossing guard shook her head...

(Kathy Bergen and Stacy St. Clair)

Beyond that, the mayor plans to borrow a to-be-determined amount to cover some of the initial interest payments on the new debt the city is taking out, which adds to the overall cost. It's the equivalent of taking out a loan to pay the initial interest on a mortgage.

Emanuel inherited the costly borrowing practices, detailed by the Chicago Tribune in its 2013 "Broken Bonds" investigation, from predecessor Richard M. Daley. Emanuel, now on his sixth spending plan, has used the techniques to prop up a sagging City Hall budget. In 2015, the mayor promised to end the costly financial moves by the end of his second term in 2019.

The administration's plans call for pricing the bonds on Jan. 18-19, when the market will determine the interest rates, and closing on the deal Feb. 1, Emanuel's Chief Financial Officer, Carole Brown, said in a web-based "roadshow" used to pitch the bonds. City finance officials also plan to meet with investors in Chicago, Boston and New York before the bonds are sold to make further pitches, a common tactic Chicago and other major cities have begun to use in recent years.

The city is likely to pay relatively high interest rates because municipal bond market rates recently increased, and continuing financial problems at Chicago Public Schools and the state of Illinois has investors concerned, said Matt Fabian, a partner at Concord, Mass.-based Municipal Market Analytics.

Fabian also said buyers would look more favorably on city debt if it stopped using "budget gimmicks" like scoop-and-toss and borrowing to pay initial interest payments "instead of just talking about how they're going to stop."

While Mayor Rahm Emanuel has reduced Chicago's use of borrowed money to plug budget holes, records show he continues to rely heavily on the practice, devoting nearly half of the $300 million in long-term bond funds spent over the past two years to short-lived expenditures.

As the City Council prepares...

While Mayor Rahm Emanuel has reduced Chicago's use of borrowed money to plug budget holes, records show he continues to rely heavily on the practice, devoting nearly half of the $300 million in long-term bond funds spent over the past two years to short-lived expenditures.

As the City Council prepares...

But he added that "the municipal market has come to see and talk about Chicago as a bit of a success story" after Emanuel set in motion plans to contribute hundreds of millions of additional dollars a year to its pension plans for police officers, firefighters, city workers and laborers.

At Emanuel's urging, the City Council in recent years increased telephone fees for emergency service, dramatically increased property taxes and enacted a new tax on city water and sewer service to help fund higher contributions to the four pension funds.

But there's uncertainty about how the city will come up with hundreds of millions of additional dollars in the early- to mid-2020s that will be needed to make even higher contributions to those funds in an effort to prevent them from running out of money. And the plans for the municipal workers' and laborers' funds have yet to be approved by a state government mired in partisan gridlock.

Nevertheless, Wall Street bond rating agencies have changed the city's debt outlook from negative to stable based on the efforts underway to stabilize the pension funds, all of which were at risk of going broke in the 2020s even if the city's general bond ratings remain low. That could result in the city paying lower interest rates than they otherwise would have when the bonds go to market this month.

Richard Ciccarone, president and CEO of Merritt Research Services, said interest rates also could go higher because of "intangible" factors not directly related to city finances, like a recent "60 Minutes" segment on Chicago's spiking violent crime rate. "Those kind of things don't help, even though they are very indirectly related to finance," he said.

Mayor Rahm Emanuel said Monday that cash-strapped Chicago Public Schools is likely to borrow against a $45 million property tax increase he’s proposed in his budget for school construction.

The CPS tax hike is part of the record $588 million property tax increase aldermen are expected to approve...

Mayor Rahm Emanuel said Monday that cash-strapped Chicago Public Schools is likely to borrow against a $45 million property tax increase he’s proposed in his budget for school construction.

The CPS tax hike is part of the record $588 million property tax increase aldermen are expected to approve...

But Ciccarone praised the mayor's efforts to fix the pension systems, reduce the city's annual budget funding gaps, rely less on short-term borrowing and beef up city budget reserves. "The city moved forward in 2016 on making real incremental progress," he said.

The City Council signed off last year on the latest round of borrowing, but the scoop-and-toss total is about $100 million higher than Emanuel finance aides told aldermen was in the works. The dollar amount went up because plans to refinance about $100 million in debt to save money were no longer possible after a recent rise in municipal bond interest rates, budget spokeswoman Molly Poppe said. The city still plans to refinance about $25 million.

Some specifics about the $1.2 billion borrowing plan:

•$440 million in scoop-and-toss borrowing, a long-term delay tactic that adds millions of dollars in interest costs to be paid by taxpayers over the next 20 years.

•About $225 million to pay legal settlements and court judgments. Other cities with sounder finances pay such costs without borrowing that adds millions of dollars to the taxpayer tab.

•About $405 million for construction projects and equipment, including new police vehicles.

Poppe defended the city's plans to borrow money to cover some of the initial interest costs, saying that's "common practice" in cases where cities don't anticipate the construction projects financed by the borrowing to be completed for a while. That way, "debt service expense does not begin until the project is operational and benefiting communities," she said.

Heather Gillers and Hal Dardick

Mayor Rahm Emanuel has reduced spending and increased fines, fees and certain taxes to shrink the chronic budget deficits left over from his predecessor, Richard M. Daley.

But four years after taking office, Emanuel still at times resorts to Daley's questionable budget tactics as the mayor struggles...

Mayor Rahm Emanuel has reduced spending and increased fines, fees and certain taxes to shrink the chronic budget deficits left over from his predecessor, Richard M. Daley.

But four years after taking office, Emanuel still at times resorts to Daley's questionable budget tactics as the mayor struggles...

(Heather Gillers and Hal Dardick)

Laurence Msall, president of the nonpartisan Civic Federation budget watchdog group, lauded Emanuel's pledge to end borrowing for scoop-and-toss and legal settlements and judgments, but expressed some skepticism as to whether the mayor could keep the promise.

"Even if the city is able to end most borrowing for operations by 2019, it faces significant financial challenges that could make it difficult to maintain its commitments in the future," said Msall, who called on Emanuel to "present a plan" for covering future debt service payments and paying off legal settlements and judgments.

hdardick@chicagotribune.com

Uptick in Muni Defaults Could Hurt More Investors in 2017

By Amey Stone

While the uptick in municipal bond defaults isn't that high, it could be more painful for municipal bond investors in the coming year, writes Matt Fabian of Municipal Market Analytics in his latest report on default trends Friday.

That's because bond insurance isn't nearly as common now as it used to be. "Credit trauma is likely to harm bondholders more directly this year and in the future," he writes.

Last year saw 65 first-time payment defaults, up from 60 in 2016. Eight of 2016 defaulters were Puerto Rico issues. However, the number of "impaired" credits declined in 2016.

He sums up the outlook:

The drop in impairments bolsters the alternative scenario outlined in the last issue of DEFAULT TRENDS: that municipal defaults are not necessarily beginning to leg higher but are instead experiencing modest volatility around a relatively low baseline. Nonetheless, MMA is comfortable advising subscribers to approach the new year expecting an uptick in default activity as emergent state budget gaps belie tax and fee revenue weakness across the government spectrum and, because of more aggressive high yield underwriting in 2016 (see OUTLOOK 1/3/17) a large universe of unseasoned project financings is poorly prepared for economic setbacks.

The iShares National Muni Bond ETF (MUB) climbed to $108.35 by Friday afternoon, a 27 cent gain so far in 2017.