Outlook 2014: Issuance expected to fall or stabilize in 2014; tax-exemption may be threatened

By Sheri Kasprzak

New York, Dec. 31 - New municipal issuance could hit a slump in 2014, some market sources have indicated, with expectations ranging from $280 billion to almost $350 billion.

As issuers shy away from new capital projects following the 2008 financial crisis, new bond deals could either stay about the same as in 2013 or substantially decline.

George Friedlander, chief municipal strategist at Citigroup Inc., said in a recent conference that he expects 2014's issuance to total about $280 billion. Meanwhile, Phil Fischer, municipal research strategist with BofA Merrill Lynch, expects issuance to remain about the same as it was in 2013 - $330 billion.

Respondents to the Securities Industry and Financial Markets Association's Municipal Issuance Survey expect total issuance to reach $349.5 billion in 2014, down from the $366.1 billion estimated issuance in 2013.

"Both short-term and long-term issuance is expected to fall in 2014, with $40 billion in short-term notes expected in 2014, compared with $53.6 billion issued in 2013; and $309.5 billion in long-term bills expected in 2014, compared with $309.5 billion issued in 2013," said a Sifma statement.

Total municipal issuance for 2013, between January and November, the latest available data from the Municipal Securities Rulemaking Board, was $339.37 billion.

There were 11,854 deals between January and November with the largest number of the offerings - 1,470, totaling $18.8 billion - conducted in June. The smallest number of offerings came in January with 684 deals totaling $18.33 billion.

Pressure on local governments

Local governments will continue to face pressures in 2014, including slow revenue growth and increased spending, according to both Fitch Ratings and Moody's Investors Service. Fitch expects more downgrades than upgrades in the coming year.

Moody's is also expected to downgrade more names than upgrade in 2014.

"In 2014, we expect downgrades to continue to outpace upgrades but at a slightly lower rate, and we expect that downgrades as a percentage of all revisions to lighten somewhat," said Tom Kozlik, municipal credit analyst with Janney Montgomery Scott LLC.

"Municipal issuers will continue to grapple with lower U.S. growth and other factors that are mostly resulting in lower overall spending. Some issuers will be able to continue to make adjustments. But others have been squeezed tightly since the economic downturn. For some, credit deterioration will occur and ratings will be lowered as a result."

Bankruptcies may give insight

Amy Laskey, managing director of Fitch's public finance group, said in a recent conference that taking a page from current bankruptcy cases may offer positive directions for distressed issuers, particularly ones on the brink of bankruptcy.

"Willingness to repay debts has been a hallmark of the municipal credit market, but evidence of management's failure to prioritize debt service payments in a limited number of bankruptcy cases is trouble," she noted.

"Fitch expects the current bankruptcy cases to set important precedents for other distressed municipalities. If pending bankruptcy rulings demonstrate that pensions take priority over general obligation debt service or require debt restructuring along with benefit adjustments, more cities may be encouraged to take this path. Fitch would likely re-evaluate the strength of the general obligation pledge in states where benefits are clearly placed ahead of G.O. debt."

Revenue recovery will be slow

Despite the fact that the U.S. economy appears to be making a recovery, as evidenced by recent retail sales, wholesale inventories, and other data, on the local level, revenue recovery will be slow in 2014, market sources indicated.

"While the moderately expanding economy should translate to increases in most local tax revenues, areas that have seen a strong housing rebound and are dependent on property taxes may see more robust growth," according to a report from Fitch.

"Many local governments were able to achieve significant labor savings over the last few years, although signs of labor's unwillingness to negotiate further concessions are on the increase. Even with financial market recovery, benefit spending growth will continue to put pressure on budgets in 2014. State and local pension plan reform efforts continue to be encouraging, although many will not have a meaningful impact on liabilities or annual payments for many years."

Economic headlines dominate

The fiscal cliff and its impact on the municipals market was certainly a hot topic during 2013, and the fallout from this - as well as from Detroit's bankruptcy, will continue into 2014, insiders said.

Looking to the coming year, revenue recovery will be amid the headlines, as states continue to experience pressures.

"At this point in the recovery, there is a clear contrast between the majority of states - which are experiencing sustained economic and revenue recovery, rebuilding their financial cushions and benefitting from structurally balanced budgets - and those that are still struggling," said Laura Porter, managing director with Fitch.

"As states once again show their fundamental strengths, those with fundamental challenges stand out more."

States will face pressure from below-average economic recovery, challenges like rising pension demands and management weakness, said Porter.

"The federal government remains the most significant threat to state budgets in 2014," according to a Fitch report.

"State revenue systems quickly reflect economic conditions, and to the extent federal action or inaction hurts the economy, it hurts states."

Pensions will challenge many states, with four states currently carrying a negative rating outlook because of unfunded pension liabilities or escalating annual pension costs. In fact, during 2013, the State of Illinois hit the market with $350 million of taxable G.O. bonds right after the state's legislature passed a pension reform bill that would limit pensions for the highest-paid state workers, lift the retirement age for state workers under 45 and reduce annual cost-of-living increases for state retirees, among other changes. The pension reform is a step toward helping the state fund its underfunded pension system.

2014 key for Puerto Rico

In 2013, Puerto Rico saw a lot of changes, including a G.O. debt downgrade from Moody's to Baa3 - just above high-yield - and the commonwealth faces another possible downgrade from the ratings agency.

The coming year will likely be pivotal to the commonwealth, said Alan Schankel, managing director with Janney Montgomery Scott.

The island has had made some significant improvements, Schankel said in a recent year-end report.

"As the July 1 start to a new fiscal year approached, the administration and legislature enacted significant measures, raising new revenues to narrow the budget gaps and reforming the commonwealth's woefully underfunded employee pension system," Schankel wrote.

Schankel was quick to point out that the financial measures taken by the government during the summer of 2013 have not yet been fully realized. Even so, revenues are on-target for the first four months of fiscal year 2014.

"Additionally, an increase in the petroleum tax and a 60% bump in water rates, if projections are realized, will provide enough additional revenue to put the corporations on a self-sustaining financial footing, limiting or eliminating the need for liquidity support from the Treasury and Government Development Bank," Schankel wrote.

"Impressive as these accomplishments are, severe economic headwinds persist and continue to cloud Puerto Rico's prospects, and the market has taken a dim view of the creditworthiness of Puerto Rico issuers."

A Standard & Poor's index that tracks the commonwealth posted a 19.45% negative total return year to date, according to numbers released in mid-December.

"The story plot thickens for Puerto Rico bonds as Moody's placed bonds issued from Puerto Rico under review for a possible downgrade to below investment-grade," Rieger said at the time the report was released.

"Selling pressure continues to mount impacting the market. The S&P Municipal Bond Puerto Rico index has seen a negative total return of 19.45% year to date [as of Dec. 13], and the weighted average price of bonds in the index has fallen by over 24% this year. The weighted average yield of bonds in the index ended at 7.26% or 419 basis points higher than investment-grade bonds."

Yields jump in 2013

Yields on Puerto Rico debt climbed sharply during 2013.

The differential between the yields of a 10-year Puerto Rico G.O. index and the benchmark AAA municipal index widened to 620 basis points recently from 290 bps, Schankel said.

"Although Puerto Rico general obligation bonds retain investment-grade ratings, current yield levels are consistent with high-yield municipal bonds with ratings in the B and BB categories," Schankel said.

Yields jumped to as high as 10% for G.O. bonds in early October, a key element underlying Fitch's placement of the commonwealth's G.O.s for possible downgrade.

2014 is critical

Puerto Rico could see some major improvements in the coming year, assuming those revenue projections are met.

"The administration and Government Development Bank can enhance investor confidence by continuing and further improving financial disclosure efforts," said Schankel.

The commonwealth's Sales Tax Financing Corp. (Cofina) has postponed the sale of $500 million to $1.2 billion of new debt, but if market access is not achieved before the end of the current fiscal year in June, liquidity concerns will increase, Schankel said.

Puerto Rico has relied on short-term bank loans to fund liquidity.

At the end of the day, Schankel said Puerto Rico bonds are not for the faint of heart.

"Risk is significant, and the investor mix has recently widened to include nontraditional investors such as hedge funds," said Schankel.

"Although an additional investor segment is positive, the interests of hedge funds and seminal investors are not always aligned with those of individual retail investors."

$2.67 trillion in trades

Moving to secondary action, there were 9,981,011 trades from Jan. 1, 2013 to Dec. 9, totaling $2,674,602,000,000, the latest data available from the Municipal Securities Rulemaking Board. This compares with $3.23 trillion in bonds traded in 2012 and $3.29 trillion traded in 2011, market sources said.

Between Jan. 1 and Dec. 9, 4,295,750 of the trades were customer-bought totaling $1,230,198,000,000. There were 2,257,749 customer-sold bonds totaling $853,934,000,000 and 3,427,512 inter-dealer trades totaling $590,470,000,000.

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