Interest rates were relatively range-bound last week, despite a string of disappointing economic releases. With severe weather across the country having an outsized impact on the economy of late, market participants have been treating the weak data with a high degree of skepticism. We suspect there is further room for data to disappoint relative to expectations, believing a clear reading on the state of the economy cannot be determined until the spring.
With concerns over the economy and the political instability in Ukraine dominating headlines last week, equity and credit markets were able to register strong price gains relative to Treasuries, as favorable technicals remain supportive of risky assets. With little relevance to the global economy, we suspect the situation in Ukraine will have a limited impact on Treasury rates.
Weekly 10 Year Treasury Yields versus 10 Year AAA MMD – including MMD to TSY ratio (beginning in January 2008)
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Source: Bloomberg, Thomson Reuters and Castleton Partners
Another week of limited supply and positive inflows to mutual funds contributed to tax exempts extending their 2014 rally. For the holiday shortened week, 10 year AAA yields fell two basis points to yield 2.50%, with the Muni/ Treasury ratio declining to 91%, matching its lowest level of the year. Demand for tax exempt income remains strong, as $320 million of new money was recorded in funds—a sharp rise over the prior week’s $82 million of inflows. As investors confront a bevy of higher taxes on their 2013 tax returns, prices of tax exempt bonds continue to rise, as increased demand confronts declining supply. Tax exempt supply is running 30% below last year’s level—the lowest to the start of any year since 2008. With so many bonds having matured or been called so far in 2014, net tax exempt supply has actually been negative. Castleton continues to source and find value in high quality intermediate essential purpose or dedicated tax backed bonds with taxable equivalent yields ranging between 5%-6%, depending on state tax brackets.
Supply is again expected to be modest this week with just $2 billion scheduled to price. With tax exempt volatility low and interest rates relatively range bound year-to-date, one of the more interesting loans pricing this week is a $176 million deal for United/ Continental Airlines via the New Jersey Economic Development Authority. Rated B2/ B, this deal is refunding a prior loan issued in 2000 that financed an air cargo building, maintenance facilities, and terminal upgrades at Newark International Airport. Newark is United’s third largest hub, operating nearly 400 flights per day from 72 gates. With over $6 billion of unrestricted cash on their balance sheet, United is finally benefiting from their merger with Continental Airlines as the airline industry enters its fifth consecutive year of profitability—a record since deregulation.
Though municipal trading activity was modest last week, the two prominent credit stories of 2013—Detroit and Puerto Rico—remained very much in the spotlight:
With much anticipation on the part of investors and pensioners, the City finally submitted its plan of adjustment with the federal bankruptcy court. If approved, the very much “pro union” plan would pay unlimited general obligation bond creditors twenty cents on the dollar, while police and fireman unions would receive 90% of their pensions. Though favoring city pensioners at the expense of bondholders may be politically popular, we view this plan to be contrary to bankruptcy laws where “all classes of creditors” are to be treated fairly, and suspect protracted and costly litigation against the City.
In preparation of their eagerly anticipated financing next month, the Commonwealth held an investor webcast, updating investors on recent economic developments as well as details of the financing. Faced with downgrades by all three rating agencies over the last month to sub-investment grade levels (Ba2/ BB+), Puerto Rico is expected to price nearly $3 billion of general obligation bonds, the first offering of any island credit since August and the first G.O. deal since 2012. Hedge funds and other alternative asset managers are expected to be large buyers of this new loan. In a nod to pressure from hedge funds, Puerto Rico stated they are inclined to waive sovereign immunity on this loan and agree to New York jurisdiction— effectively creating a separate class of G.O. debt if such provisions are not extended to outstanding bonds. Proceeds from the sale will balance budgets and refinance existing debt. Following the webcast, all debt of the Commonwealth experienced a sharp rally, particularly G.O. and Cofina credits.
Further aiding prices of Puerto Rico debt was the announcement by the Puerto Rico Supreme Court upholding and ratifying the changes by the legislature to the island’s employee and teacher pension systems.
AAA Municipal Market Data (MMD) Yield Curve
Source: Thomson Reuters
Weekly Municipal Mutual Fund Flow Data
Source: Lipper AMG Data
Investment grade bonds tightened, on average, 2-4 basis points last week. Continuing to take advantage of low financing costs, over $25 billion of new debt was priced, led by a $1 billion loan by tech giant Google. Google priced a new 10 year loan at a spread of +62.5 over comparable maturity Treasuries. Though we disagree with the premise, one of the reasons corporate debt has rallied over the last month is the view that, in the face of disappointing economic data, the Federal Reserve will stop or reduce their tapering program. Again, we refute this perspective. With credit spreads trading at post financial crisis tights, we remain neutral on investment grade taxable debt, feeling a material tightening in spreads from current levels is limited.
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Via James Welch of castleton Partners