This market and credit commentary is brought to you by Neighborly and Court Street Group. For a PDF of the full CSG report, click here.
Market Trends to Watch
In a fairly consistent manner, municipal borrowing rates have increased since the start of the month when markets rallied in response to a lackluster jobs report. This move into higher yield ranges was accentuated this past week with rates rising on leading benchmarks increasing anywhere from 5 to 15 basis points, depending on credit.
The municipal borrowing costs were following the lead of the Treasury market, which lost even more ground. This was the result of market participants’ perception that the damage of Hurricane Irma was not as bad as anticipated and that Korea did not launch missiles over the weekend, which resulted in an “unwind” of the flight-to-safety trade that had occurred the week prior. Oddly enough, Korea’s launch late last week was largely shrugged off by the markets.
As far as municipal-specific items, the industry saw a 9th straight week of investors putting money on a net basis into mutual funds that purchase municipal bonds. This past week the flow was $241 million, according to Lipper. Two items of concern, though, is that we have seen a decline in the amount of cash flowing into mutual funds over the previous four weeks. With the market losses since the start of the month, this could portent market outflows next week.
In the secondary market, we also noted elevated bids-wanteds. This means that investors and dealers are attempting to lighten their municipal inventories at a higher pace and this usually only acts to increase the rate at which yields rise.
Heading into this week, there are 9 deals of more than $100 million coming via negotiation with the total volume looking to be about $5 billion. With a light competitive calendar, overall new-issue supply is below historical averages for this time of year. This should benefit issuers who are coming to market near-term.
As far as specific structures, we continue to see larger demand for the 2025 to 2029 ranges of high-grade credits with 4% coupon structures. Larger banks have been buyers here. The shorter part of the curve continues to underperform, especially in the 5-year part of the curve. The short end had gotten extremely rich, so some modest upward adjustment is unsurprising.
HOW RESILIENCY MAY BECOME A CREDIT ISSUE FOR ISSUERS
Even though the damage and replacement costs caused by Hurricane Irma can’t yet be precisely assessed, the cities impacted by the storm are facing the fact that resiliency has become a credit issue. Before the storm had even struck, the mayor of Tampa indicated that one of his greatest concerns was the ability of the city's storm water drainage system to withstand the expected demand. He pointed out that the system was not only old, but also that its maintenance had not been a high-priority item. As a result it was unclear as to what the system's actual capacity was, let alone its structural integrity.
This serves to highlight one of the major points of debate in the discussion of the Trump Administration’s infrastructure plans. On one hand, we hear the clamor for new projects designed to handle recent and expected growth – whether it be urban transit or rural broadband. These items are supported by the President's stated preference for the new and visible – so-called shiny objects. On the other hand, we hear the lament regarding outdated and aging infrastructure, from century-old core water and sewer infrastructure to highways and bridges nearing the end of their expected lives.
Events such as Hurricanes Harvey and Irma expose the need for both types of investment. Some areas are growing despite the lack of sufficient infrastructure, while the very hard hit west side of Houston showed the perils of development getting ahead of itself. The lack of flood mitigation infrastructure in recently developed areas worsened the flood’s impact. The last time a storm of this magnitude hit Tampa was 90 years ago when the area population was 300,000. Since then the area of vulnerability has grown tenfold.
As the two regions dig out and dry out, how much investment will be necessary and which type will get priority?
Maintenance generates cost and generally no new growth to cover it, while expansion generates growth but does nothing to mitigate existing vulnerability. It creates a Hobson's choice for managers and planners. Both options obviously need significant capital and revenue to finance that capital. This choice isn’t getting any easier, since the federal proposals to date provide little in terms of outside capital but creates greater demand for local revenue.
History tells us that the credit impact, in terms of actual ratings, is likely to be not that great. But will the market decided that the cost of higher levels of debt and greater levels of required revenue from local economies should not impact valuations on an absolute and/or relative basis? In the end it is the market's call. But it is something that must be considered as we view the aftermath of these and future similar events.
WHAT IT MEANS FOR YOU: Given the rather spectacular nature of recent damage, we expect both the market and rating agencies/entities to begin to incorporate resiliency into the rating/pricing process. If anything, the market will be looking to generate a hierarchy of factors related to resiliency. If anything, climate change, rising sea levels, and potentially stronger storms magnify the need for such parameters. Resiliency as a credit factor will affect all issuers. We will weigh in over time.
FLORIDA HURRICANE CATASTROPHE FUND MAY ISSUE NEW DEBT, BUT RISKS ARE LIMITED
The Florida Hurricane Catastrophe Fund (FHCF) was established by the Florida legislature in 1993 in response to Hurricane Andrew. The FHCF provides additional insurance capacity for the state by reimbursing residential property insurers for a portion of their catastrophic losses. It is statutorily authorized to collect annual premiums from residential property insurers, issue debt to support incurred losses, and issue emergency assessments on all property and casualty insurance lines (except workers' compensation/health, federal flood, medical malpractice, crop). Participation in the FHCF is mandatory for insurers, with limited exceptions, writing residential property insurance in Florida.
The municipal market impact will be the likely need for the Fund issue debt to rebuild its asset base after the storm, as it has on prior occasions. Fortunately the Fund's assessment mechanism is proven and the statewide premium base against which assessments are levied remains substantial. So for bondholders, we do not see any real credit risk associated with the bonds as the result of the storm.
Fortunately for Floridians, the state experienced about 10 years without a major storm event. This enabled the Fund to build up its resources by borrowing in the municipal bond market four times. That debt amortized rapidly, such that some $2.7 billion is outstanding. The Fund reported net assets of $12.7 billion as of the end of fiscal 2016. While the Fund will face substantial costs associated with Hurricane Irma, its revenues provide debt service coverage of 26 times on its bonds.
IRMA'S TRAIL ADDS TO PRESSURE ON CARIBBEAN CREDITS
While not far apart, the impact of Hurricane Irma varied widely between the Commonwealth of Puerto Rico and the U.S. Virgin Islands. San Juan, Puerto Rico's main port, has fully reopened to commercial traffic, as have most other ports on the island. Guayama, Mayaguez and Culebra are open with restrictions. In the U.S. Virgin Islands, many ports remain closed or are restricted to ferry traffic only, especially on St. Thomas.
Property damage was much more widespread with St. Thomas experiencing the worst. The storm severely damaged the main hospital in St. Thomas requiring the evacuation of patients to facilities in Puerto Rico. The situation in the VI will be exacerbated by the fact that the government had applied much of the funding it had received for hurricane preparedness and recovery to patch over holes in recent operating budgets. As a result the impact on its fiscal affairs will be that much more dire.
The government reported obstacles to obtaining assistance from the Federal Emergency Management Agency, including the fact that the stations distributing food or water in rations are difficult to find without power or cell service.
In Puerto Rico, the power grid was damaged initially leaving 3 of 4 customers without power and 1 of 5 without water. The damage occurred in addition to the already weakened state of the PREPA infrastructure system as the result of the island's ongoing financial difficulties and lack of access to capital.
These issues clearly affect both island’s credits, with both already having been under serious pressure. We’ve know about Puerto Rico’s situation for a long time, but the Virgin Islands issues have come into clearer view this year. Recall that the Virgin Islands had to cancel a bond sale this year because they could not find buyers at an interest rate that was not penalizing. Headline risk from both territories may have a knock-on effect for the entire market in that some investors may sell their holdings of these credits and it shines light on problematic issuers, generally.
FORT BEND COUNTY MISSES PAYMENT DUE TO ADMINISTRATIVE PROBLEM CAUSED BY HARVEY
Meanwhile, turning to Texas, Fort Bend County missed a September 1, 2017 principal and interest payment on its General Obligation Bonds due to an administrative oversight. The County had adequate funds on hand to make the scheduled payments, and did so on the next business day, September 5, 2017. Management reports the delinquency was due to an unforeseeable weather event (Hurricane Harvey) whose impacts prevented the timely transmission of funds to make the county's scheduled principal and interest payments. The county's emergency management planning included execution plans for the core functions of the municipality. These emergency protocols did not address the payment of debt service on the county's bonds. Going forward, management reports that emergency protocol is being amended to specifically include provisions for payment of debt service.
It would have been a surprise if some entity did not miss a scheduled payment due to the impacts of such a major natural disaster. When they occur, as was the case with this one, it is not for lack of funding or intent but administrative and access issues. So in the end, it is not an issue for the credit and should not be a factor in its evaluation.
For a deeper dive on market, policy and credit implications for municipal issuers, see Insights and CSG's Municipal Perspective, which can be found here.
Joseph Krist is a Partner at Court Street Group Research who has spent his career researching, analyzing and writing about municipal credits for both buy and sell side clients.View author