The first week in February may have fostered a feeling of foreboding for many in the municipal market.
The president’s State of the Union speech on Tuesday left us with a sense that we were idling in neutral with no clear destination with respect to infrastructure. A day earlier the Title III bankruptcy court handling Puerto Rico’s debt restructuring dealt a blow to the market with respect to the safety of the revenue bond pledge.
Expectations for the State of the Union were stoked by some early reports that infrastructure would somehow be highlighted in the address. Alas, the early reporting was not well founded.
Although there was a clear reference to infrastructure, there was not a very demonstrative and explicit degree of commitment to the idea. I would not be overstating the case that details were lacking, not to mention any references to funding. It is hard to think about how infrastructure will rise to the top of the agenda with all of the other topics swirling about at present.
It is hard to continue to be optimistic about the chances of action in this session. I am starting to believe that infrastructure will be relegated until after the election once again. In the meantime, projects need to progress.
It is heartening to see that states and localities are taking the initiative on many projects that would otherwise be foundering. Yet, the states and localities cannot devote as many resources as are necessary to all of their critical projects. The financial framework from the federal level on down needs to be recast before we all start to zoom around in our autonomous vehicles.
We are not likely to see a lot of momentum on this front until the federal budget proposal is released later this month or early next month. Given the ever widening federal deficit in good times due to the tax reform, it is not easy to ponder what would happen in a recession. The funding of the deficit and the servicing of the debt is taking an ever growing slice out of the budget.
There have been calls for increasing the gas tax, expanding private activity bond capability, and bringing back advance refunding. The challenge is we do not really know who will be the proponents of these cause celebre initiatives in Congress. Given the budget scenario, the prospects of these proposals coming to fruition is questionable at best.
One positive development coming out of the provisions in the Tax Reform is the promise of Opportunity Zones (OZ). Numerous zones across the states have been identified for this special treatment under the code. The incentives in the OZ provisions are mainly targeted to real estate projects in more blighted or underutilized areas. Developers and investors would benefit from an array of tax credits and other favorable treatments over the period provided for in the legislation that appears to be 7 years. There are many discussions underway in the different locales about how these projects may be approached. The industry awaits the federal rule writing that would have been released earlier if we had not had the government shutdown.
The prospects for municipals that will flow from the OZ projects would probably be companion financings. Basically, infrastructure improvements will probably be necessary in the OZ’s to allow the real estate development to go forward. It is early in the development of the necessary rules and we will not know all of the possibilities until the guidelines become more concrete. Hopefully, the rules will be streamlined and will not be as complex as they have been for other new Programs.
The other perplexing tectonic shift coming to the fore in the muni market concerns revenue bonds and in particular, special revenue bonds. The COFINA ( Puerto Rico Sales Tax bonds) settlement, which gives senior bond holders 93 cents on the dollar and subordinate holders 56.4 cents, has contributed to revisiting many of the tenets of the municipal market that are held with strong conviction. The beauty of a revenue bond has always been the clear dedication of the revenue source to the repayment of the specific bond under consideration. Primary lien and subordinate lien holders always have somewhat different expectations but they have always been united in the conviction that they should be repaid in full. Whether the repayment is timely has always been a bit more of a concern for the subordinate holder.
When I started in the business and revenue bonds were not quite as prevalent as they are today, we always said that concerning revenue bonds that it is the quality of the coverage and not simply the quantity. Higher coverage should always be looked upon as providing a buffer but it does not solve all considerations of the fundamental credit. In some respects, legal provisions sought by potential buyers will provide an extra layer of protection in a similar fashion. But a strong legal provision provided on a weaker credit will probably not provide as much protection as intended.
We truly need to have real faith and trust in our revenue bonds. I am not talking about blind trust. But how much additional legal language will we need in order to become comfortable in today’s environment? Or, can we reach this status?
I am reminded of when I was engaged in bringing to market a lot of leases and certificates of participation. By definition, the lack of a specific pledge versus the appropriation meant that these securities would be viewed as possessing security that was not as strong. I would explain to my corporate counterparts that we had a leasehold interest in the project due to the prohibition of the gifting of public assets. My corporate counterparts were very uncomfortable without a mortgage because of the conviction that pursuing remedies without one would be difficult at best. In many respects, these observations were valid. But these doubts did not hold back the market. Most governmental entities enter into these financings because there is a real need for the project or the improvement. They would not want to abandon the project and forsake bondholders just on a whim.
The adjustments in ratings in the special revenue sector that are taking place at this time are quite something to behold. One may intellectually appreciate the argument concerning the pledge, but the outcome is turning out to be quite harsh.
How we contend with a distinct lack of federal action on infrastructure and a direct challenge to the bedrock belief in the pledge for revenue bonds may determine the narrative and some of the practices in the municipal market over the remaining course of this year.
