CHICAGO — Puerto Rico's imminent insolvency is a game changer that will have a deep and far-reaching impact on the market, municipal professionals said Tuesday.
Their assessment came during The Bond Buyer's Midwest Municipal Market Conference in Chicago.
"I'm afraid the new normal is going to change" after the weekend's events, said veteran municipal professional David Johnson, a senior managing director at Mesirow Financial Inc., predicting "a very different environment over the next six months."
While warnings had been long been circulating about looming defaults, Puerto Rico's government shook the market with its disclosure that it would pursue a restructuring of $72 billion in public debt.
Johnson and others see a wide ranging reverberation that will impact investor products, whether a buyside participant holds Puerto Rico debt or not, to liquidity issues and market confidence.
"We live in a very fragile market," he said, in which the dynamics are easily knocked out of balance, he said during a panel discussion on the market outlook and supply and demand.
Justin Hoogendoorn, managing director in the strategic analytics group at BMO Capital Markets, said one concern is the disruption that could occur if Puerto Rico drives big mutual fund outflows.
That said, Johnson expressed confidence in the municipal market's ability to withstand the impact, citing past turmoil from Meredith Whitney's prediction of widespread defaults that never came to fruition to derivative abuses of the 1990s. "This is not something we haven't dealt with before," Johnson said.
On the local front for conference participants, Chicago's credit ratings deterioration driven by massive pension underfunding and the state's longstanding budget and pension problems force other local issuers to pay even higher borrowing costs. On the supply side, many issuers remain focused on maintaining their balance sheets and credit ratings, with new debt issuance on the backburner.
The market has long demanded at least a 25 to 50 basis point penalty on credit spreads for Illinois-based borrowers, but some now face higher costs and buyer interest has shifted.
Sufficient spread lures mutual funds even on some wobbly credits while insurance companies tend to limit exposure on certain names, said Hoogendoorn. "There's definitely an impact" on pricing, he said, citing a highly rated Lake County credit that saw a 50 basis point penalty.
Others said they are seeing spreads widen even further on top credits, hitting as much as 100 basis points. Chicago, hobbled by a speculative-grade Moody's rating, saw a nearly 300 basis point spread on some maturities in its recent general obligation sale. The city is expected to return to the market the week of July 13 with a $1.1 billion GO restructuring.
The city and state's woes offer opportunities for some buyers, with banks taking advantage of the added yield on smaller credits and mutual funds with high yield fund lured by the spreads on Chicago, panelists said.
Moody's dropped Chicago and the school district to speculative grade ratings in May primarily over sizeable pension woes and budget strains. If a structurally balanced budget can't be reached at the state level, Illinois faces the prospect of falling into the triple-B category.
The city's rating disparity from Ba1 on the low end to the single-A level on the high end has driven a lively discussion over the role of ratings in buyside assessments, the need for independent research, and ratings shopping.
Moody's Investors Service managing director Gail Sussman said the discussion is healthy because ratings are just one tool to assess a credit's value; she sought to stress that outliers are rare.
"The reality is the market is really very stable," Sussman said. "The whole municipal market is not what we see on the front page of the newspaper."
Illinois borrowing has dramatically fallen this year with leaders' attention focused on a new budget, pension reform, and new GOP Gov. Bruce Rauner's proposed business and political governance reforms. Rauner and the General Assembly's Democratic majority are locked in a stalemate that likely means the state will enter fiscal 2016 Wednesday without a spending plan in place. Democrats on Tuesday were discussing the adoption of a one-month temporary budget. Rauner has previously said he would veto a temporary spending plan.
The question was raised over the value offered by the newcomer in the ratings market, Kroll Bond Rating Agency. Johnson attributed the firm's gains to the feedback he's gotten with issuers and market participants praising the "quality of their product."
Hoogendoorn said that with $90 billion of excess funds available for reinvestment over the summer, "there could be a fair amount of outflows and we could have stability in the market."
Panelists were mixed on refunding levels anticipated for the rest of the year. They could remain solid as issuers rush into the market ahead of an expected hike in the federal funds rate later this year or could drop off because many issuers have already taken advantage of potential refunding candidates.
Scott Richbourg, head of public finance at Build America Mutual, sees continued growth for the insurance sector which doubled its coverage levels to $14 billion for the first half of the year compared to the same period in 2014.
Richbourg sees the sector as better positioned to withstand news of troubled credits, due to industry changes since the sector's collapse in the previous decade. "We all take much smaller credit risk," Richbourg said, so no single issuer's credit woes act as a "dominant force" that impacts the company. BAM limits its exposure on any single credit to $115 million.