Municipal Credit Consultant
SOME THINGS NEVER CHANGE
Here we are at a point in the cycle where rates are at a cyclical if not an historic low. There is a mixture of opinion about the pace and direction of rates, the sustainability of current economic conditions, and the potential impact of changes in those variables. The municipal market is seeing consistently strong cash flows and yield oriented investors seem to be willing to stretch in terms of both duration and credit. So it is a perfect time for the market to accept a credit with significant downside.
It is in that context that we review an offering from the Port of Greater Cincinnati Development Authority of taxable securities to finance the construction of a suburban hotel. The list of stand alone, hotel revenue based financing disappointments is fairly extensive with many high yield funds. They have failed to meet revenue projections in suburbs throughout the country including some of the largest metropolitan areas.
The first red flag is the issues status as a Rule 144A offering made only to “qualified institutional investors”. The transfer of the bonds is also restricted. This could create problems for holders seeking to liquidate holdings in the event of any adverse credit changes.
Like many of these hotel projects, the planned facility will count on significant corporate related demand not only for rooms but for meeting, function, and dining facilities. many of the hotel projects which counted on this sector of the hospitality market have experienced shortfalls in demand. This reflects the high elasticity of demand for these facilities and the vulnerability of that demand to rapid changes in corporate spending as the events they are designed to serve are often among the first corporate expense categories to be reduced during times of economic downturns.
The project bears an number of other risks. The financing is essentially secured by a single asset owned by an entity controlled by one individual. There will not be a corporate “deep pocket” available to bail out the project. That heightens the risks associated with siting and location of the facility which has access to but is not directly adjacent to the nearest interstate highway. The site itself has its issues as it is located on a remediated former manufacturing site.
All of these risks are to be mitigated by a security pledge of “Gross Hotel Operating Revenues”. While it is true that these monies do go through a “lockbox” mechanism, operating expenses of the facility will be paid out prior to the provision of funds for debt at the project rather than just an assumed level of demand. There is projected to be additional revenue generated from the lease of office space at the site. Hotel revenues are projected to provide 1.20 times coverage. Office revenues are projected to increase this cushion to 1.7 to 1.8 times over most years of the deal.
So this is all well and good but why should an individual care? It is only being sold to “qualified institutional investors” after all. Well if you own a high yield mutual fund or ETF, you could very well own a piece of this deal that will contribute to your income but become a drag on the net asset value of your fund or of the value of your share of an ETF. So I argue that most of it does wind up being owned by individuals albeit by proxy. So that’s why you should care.
POLITICS AND CREDIT
Excuse us for the New York-centric nature of this comment but we see before us one example of political risk in municipals. This time it involves the venerable NYC Water and Sewer Finance Authority Credit and Mayor Bill DeBlasio who is facing an election for a second term in 2017. The mayor’s political troubles are well documented. He is apparently concerned about his perception among “outer borough” homeowners who have been a source of difficulty for incumbent mayors. Trying to seriously reform the property tax system is fraught with political complications the resolution of which create many competing winners and losers. So he decided to throw them a bone that he could effectively take credit for.
Mayor Bill de Blasio proposed a $183 summer credit on the water and sewer bills of over 664,000 homeowners, representing almost 80 percent of all customers. The one-time credit would have come from the Administration’s decision to no longer request a rental payment from the NYC Water Board, saving $244 million in FY17 and $268 million in FY18. The Mayor has the authority to request or decline to request the rental payment. The decision to not take a rental payment is the first time this has occurred since the City originally leased the water and sewer systems to the Board in 1985.
The politics of the decision were easy. One to three-family households would have received the $183 automatic credit in their bills this summer. It would represent a nearly 17 percent savings on the annual water and sewer bills for a typical single-family homeowner. For approximately 150,000 homeowners, many of whom are seniors, who use less than 95 gallons of water per day and pay the minimum charge, the credit represents a nearly 40 percent savings on their annual water and sewer bills.
Alas, three Brooklyn real estate companies and the Rent Stabilization Association, a landlord group, filed a petition in court to stop the city’s proposal, which also included a rate increase of 2.1 percent and was set to go into effect on July 1. The rate increases would have affected landlords across the city, most of whom would not receive the credit, and by extension their renters. The administration argued that the credit, which was to apply only to one- to three-family homes, was made possible by the city’s decision to no longer request a “rental payment” from the water board, an independent public benefit corporation, leaving it with a surplus.
This week, State Supreme Court in Manhattan ruled that the actions of the water board in authorizing the one-time payment along with a general rate increase was “an abuse of discretion” and exceeded the board’s authority. Because the city “failed to demonstrate” that it had the authority to approve the rate increase and the bill credit, “the resolutions were arbitrary, capricious and unreasonable, as a matter of law.”
Fortunately, the Mayor’s politics have not negatively impacted the Authority’s credit and have not seriously harmed holders of one of the New York market’s more widely held credits, institutionally and on a retail basis. It is disturbing nonetheless to see the Authority’s credit involved at all in the Mayor’s political activities.
MORE PR LITIGATION
A hedge fund group sued the Commonwealth of Puerto Rico; Alejandro García Padilla, in his official capacity as governor; Treasury Secretary Juan Zaragoza; and other officials after restructuring negotiations broke down Tuesday. Plaintiffs’ counsel, said: “Governor Alejandro García Padilla has willfully violated the first priority guaranteed to general obligation bonds by Puerto Rico’s Constitution and has flouted centuries-old federal constitutional protections for contract and property rights. The Moratorium Act is transparently unlawful.”
After the talks broke down, the GDB released details of the heretofore confidential negotiations. These details will undoubtedly make some investors unhappy with decisions they made without the benefit of this information. The Commonwealth was prepared to provide approximately $15.0 billion of incremental debt service to the GO and Commonwealth Guaranteed (“CW-Guaranteed,” and together with the GO, the “GO Holders”), COFINA Senior and COFINA Subordinated creditors via a revised proposal (the “Revised Proposal”), which contemplated GO Holders, COFINA Senior and COFINA Subordinated creditors receiving new debt implying a recovery of approximately 81%, 80%, and 60% of par plus estimated accrued interest as of July 1, 2016, an additional $1.0 billion of cash interest over the first four years, provided through both the increase in the face amount of cash pay debt and an increase in the cash interest rates, PIK interest for the differential between 5% and the cash interest rate paid during the first four years, for a total of 5% yield through the life of the bond, the removal of the CAB feature, and consequently, and an improvement in final maturity for the majority of the GO and COFINA creditors.
Debt service on GO and guaranteed debt would have increased gradually over the next 15 years and then leveled at $878 million annually through 2060 with final payment the next year. Senior COFINA debt service would have followed a similar pattern leveling at $389 million annually through the same final payment schedule. Subordinate COFINA debt service would have reached an annual level of $310 million in five years with balloon payments in 2062 through final maturity in 2066. Combined debt service would be $1.8-1.9 billion through 2039 and $2 billion through 2070.
The GO creditors countered at an 11% haircut and a stepped bond structure that would have included no principal repayment for five years. The plan would have restricted issuance of additional debt and forced any future litigation into New York based courts. COFINA bondholders proposed maintenance of the COFINA structure and first lien on all COFINA revenues and assets, a smoothing of pledged sales and use tax base amount (“PSTBA”) in order to grant the Commonwealth interim liquidity relief, subject to agreement on sufficient collateral cushion and mechanism, an amortization schedule, including 5-year principal holiday and maturity extensions, and partial PIK interest for the first 4 years, as had been proposed by the Commonwealth. COFINA senior creditors asked for a base bond equal to 95% of the principal amount of bonds outstanding (accreted amount for CABs) at the time of the exchange, a 5.17% coupon for tax-exempt bonds, ratcheting down to 5% upon BBB+ rating, and that sub debt not begin amortizing until after full payment to seniors.
So that is what was on the table when talks broke off. The governor said the counter proposals offered only limited short-term liquidity and basically expected Puerto Rico “to roll the dice on future growth while locking into a debt burden that no other U.S. state faces.” Now it’s off to the courts absent further discussions. And a full default is but 8 days away. The pressure now shifts to the U.S. Congress to try and fashion a plan for Puerto Rico to find a way out of this mess.
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