Prices of top-quality municipal bonds finished stronger on Tuesday, traders said, with yields on some maturities falling by as much as five basis points.
The market's attention was focused on two big deals coming from the city of Chicago and the state of Pennsylvania.
Primary Market
On Wednesday, Pennsylvania will competitively sell $1.2 billion of general obligation bonds, consisting of $460 million of second Series of 2015 and $770.2 million of first refunding Series of 2015. The bonds are rated Aa3 by Moody's Investors Service and AA-minus by Fitch Ratings. The Pennsylvania Series 2015-1 GO 5s of 2020 were yielding 1.92% on Tuesday compared to 1.95% in the previous session, according to Markit.
The Keystone State last sold bonds competitively on Feb. 3 when Bank of America Merrill Lynch won $1 billion of First Series of 2015 GOs with a true interest cost of 2.99%.
Also on Wednesday, Chicago will offer $645 of fixed-rate bonds to convert $800 million, with the remaining funds needed to redeem the floating-rate paper coming from its short term borrowing program. The city will offer $172 million from its $200 million 2002 issue, $169 million from its $180 million 2003 issue, $162 million from its $222 million 2005 issue, and $143 million from its $200 million 2007 issue.
All will include a mix of serial and term bonds with the respective final maturities in 2037, 2034, 2040, and 2042, according to an investor presentation posted late Friday with the deal's offering statements. The city will make a total of $200 million in swap termination payments due to negative valuations on derivatives tied to the bonds.
Bank of America Merrill Lynch will be running the books with Citi, Ramirez, and Siebert Brandford Shank as co-senior managers. Another eight firms round out the syndicate on the transaction. Columbia Capital Management is advising the city.
The sale comes on the heels of the city's downgrade to Ba1 with a negative outlook from Moody's Investors Service over the challenges posed to city pension reforms by a state Supreme Court ruling voiding state pension changes.
Fitch Ratings and Standard & Poor's also downgraded the city, though it kept Chicago at an investment grade levels, to BBB-plus and A-minus, respectively, citing liquidity risks posed by the Moody's downgrade. Kroll Bond Rating Agency affirmed the city's A-minus rating and stable outlook.
Chicago bonds currently trade at about 300 basis points over the MMD's triple-A scale. In contrast, the state of Illinois GOs (A3/A-minus/A-minus) trade around 170 to 185 basis points over the MMD scale.
Illinois & Chicago: Effects May Be Felt Beyond Midwest
On May 8, the Illinois Supreme Court ruled that changes the state made to its pension systems were unconstitutional. On May 12, Moody's downgraded Chicago's rating to junk level, saying that city will face increased fiscal pressures since the court's decision on state pensions will limit the city's ability to modify its pension systems.
"Stepping back from the headlines of the day and surveying the muni landscape, we believe the Illinois ruling could return the hot pre-crisis topic of pensions and OPEB (other post-retirement benefits) to the foreground," John Dillon, Managing Director at Morgan Stanley Wealth Management, writes in a new market strategy report. "As a key variable in our long-standing assertion that the muni market is moving away from its rate-sensitive and credit-homogenous roots and toward an idiosyncratic credit-sensitive arena more akin to U.S. corporates, the foreground is exactly where it should be."
Some also believe that the events in Illinois will have a wider market impact.
"In our view, this development has resulted in a feedback loop with negative implications for the broader market," according to a new report from Citi Research.
A feedback loop is created by a payment-induced liquidity shock, the knock-on rating downgrade risk, a shrinking buyer base, and rising issuance costs, writes Vikram Rai, head of municipal strategy at Citi.
For many issuers' credit contracts, a drop to a speculative grade rating can act as a payments trigger. "For instance, the issuer may have commercial paper programs and line of credit agreements as a part of its short-term borrowing program and a rating downgrade could qualify as an event of default," Rai writes. "Thus, as a result of the rating action, an issuer could face increased liquidity risk at an unfortunate time when it is working to navigate its way out of a fiscal crisis."
Rating agencies may also disagree, which might result in a split rating. "A drastic rating action by one main rating agency, which knocks the issuer's debt to below investment-grade, could force the other rating agencies to follow with a similar downgrade," Rai said.
And buyers could also be forced to dump the debt, which would drive up issuer costs. "Many investors have mandates to buy investment-grade debt only and a fall to speculative-grade status could cause existing investors to liquidate the holdings," Rai wrote, adding that a smaller buyer base translates into a higher debt cost and "a higher cost of debt exacerbates liquidity problems and thus the feedback loop could continue to gain traction."
Additionally, the consequences of the recent actions in Illinois may be felt for many years to come, and in many places.
"Despite the initial price adjustments, with greater differentiation among credits comes higher volatility, wider spreads and better opportunity for investors to be paid for risk. In the pre-crisis muni market, credit spreads and volatility were constrained by the prevalence of bond insurance," Dillon wrote. "With bond insurance penetration currently 6% (versus over 50% in 2005) and investment-grade spreads near pre-crisis averages, the next act may play out in state Supreme Courts throughout the land over a period of many years."
Secondary Market
The yield on the 10-year benchmark muni general obligation on Tuesday fell five basis points to 2.25% from 2.30% on Friday, while the yield on the 30-year GO was down five basis points to 3.23% from 3.28%, according to the final read of Municipal Market Data's triple-A scale. Trading was steady in an active session, according to Interactive Data.
Treasury prices were higher on Tuesday as the yield on the two-year Treasury note dropped to 0.61% from 0.62% from Friday, while the 10-year yield decreased to 2.13% from 2.22% and the 30-year yield declined to 2.89% from 2.99%.
The 10-year muni to Treasury ratio was calculated on Tuesday at 105.3% versus 103.5% on Friday, while the 30-year muni to Treasury ratio stood at 111.6% compared to 109.6%, according to MMD.
Prior Week's Most Actively Traded Issues
Among the most actively traded issues in the week ended May 22 were issuers from Chicago, New Jersey and Sacramento, according to Markit.
Broken down by market sector, revenue bonds comprised 54.24% of new issuance, down from 55.53% in the prior week. General obligation bonds comprised 37.85% of total issuance, up from 36.75%, while taxable bonds made up 7.91%, up from 7.72%.
In the revenue bond sector, the New Jersey Economic Development Authority 5s of 2026 were traded 379 times. In the GO bond sector, the Sacramento Unified School District 4s of 2040 were traded 198 times. And in the taxable bond sector, the Chicago Board of Education 6.519s of 2040 were traded 54 times, according to Markit.
