Seems like I don't hear about municipal bonds much anymore.  But they have been performing quite well.  Their prices had cratered going into the 2016 election, but almost immediately reversed that trend.  Since the election the Muni Bond ETF ($MUB) is up 4.7%, and that is after giving back some gains since the beginning of September, some likely related to the hurricane damage this fall.  

The chart below though gives rise to the question of whether the recent pullback is just the ETF catching its breath, or a change of character for municipal bonds.  It shows the rise off of the November 2016 low, crossing back above its 200 day SMA in May and continuing.  The rise found rising trend support as it continued higher through to October.  But then price broke below that support.  It did not stay there long though and moved back above it Tuesday.

Municipal Bonds have tended to follow the same path as other debt instruments.  When the Treasury and Taxable debt world start to break down though the call to keep municipal bonds for tax purposes strengthens.  Can they really be a good investment all of the time? Maybe.  But without regard to the tax implications, the prices of municipal bonds are sitting at a critical juncture.  The chart below explains.

After a strong run higher from mid 2013 until the end of 2014 they started to fall back.  But it was a short lived decline and in May 2015 they started back higher again.  That run ended with a Shooting Star reversal candle the Fourth of July week in 2016.  It has been falling since then.  Will the fall continue or is it over and a new run higher about to begin?

There are 3 things to watch in the chart that can help determine this and where municipals might end up. First is the 100 week SMA.  This moving average sitting just below halted the last decline at the lower Bollinger Band®.  With price at the Bollinger Band now watch to see if the 100 week SMA holds as support.  

Like many assets, muni bonds have enjoyed significant appreciation in recent years; that rally may be in jeopardy, however.

Seeing as though it’s Trendline Wednesday (see our streams on Twitter and StockTwits: @JLyonsFundMgmt), it is appropriate that our Chart Of The Day highlights a currently relevant trendline. And while it may not be the most significant data point in the financial markets, the chart does contain a rather exquisite trendline -- for those of us who are into such things. The series in question pertains to municipal bonds, specifically, the iShares Municipal Bond ETF (ticker, MUB). MUB has been on a steady uptrend in price since it essentially crashed in 2008, along with most financial assets. This uptrend is squarely being tested at the moment.

As the chart shows, the Up trendline at play here begins at the October 2008 panic lows in the fund. Now, whether those low prints back then represent the accurate market at the time or skewed prints due to an illiquid market, we’re not sure. But we don’t care either. Valid trendlines have a way of materializing under normal or illiquid conditions. In this case, we drew a trendline on an unadjusted log scale chart of the MUB beginning at those 2008 lows and connecting the June 2013 “taper tantrum” and September 2013 lows. Extending it further, the trendline precisely connects the September and November 2015 lows as well.

Guess where the trendline is intersecting right now. Yes, right at current prices, just above the 112 level.

As we often say, when the frequency of trendline touches increases, so do the odds of the trendline breaking. With the multiple touches over the past year, this trendline may be in jeopardy of breaking. If it does, the loss of upside momentum and support would certainly be a negative for muni bond bulls.

It wouldn’t automatically mean the post-2008 bull market is over, nor that a sizable correction is assured. However, a break of the trend would likely usher in some selling pressure in the short-term and probably some sideways consolidation, at least, in the intermediate-term. At a minimum, the trajectory of the rally will necessarily be shallower.

One factor that may help the MUB continue to hold this trendline, for now, is potential support stemming from the fund’s springtime breakout. As we posted at that time, the MUB was arguably breaking out of a cup-&-handle formation (2 of them, in fact), a pattern with bullish ramifications. The resultant breakout saw the MUB follow through by a couple percentage points into mid-summer. Since July, however, MUB has been on a steady retreat that has now brought it to the level of its spring breakout -- just above 112. This added measure of support here suggests the MUB may, at least temporarily, hold its post-2008 Up trendline.

Eventually, however, we have doubts about the likelihood of MUB maintaining residence above the trendline. The increasing frequency of trendline touches and MUB’s inability to mount much of a lift anymore off of the trendline points to a pending breakdown. We’re not calling for a collapse of the muni bond market off of an ETF trendline break. After all, if any market truly is “local”, it is muni bonds. However, the MUB does have a fairly high correlation to the broad muni market. Thus, a breakdown below this trendline may possibly spell the end of the road for this recent run in munis.

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More from Dana Lyons, JLFMI and My401kPro.

A typically bullish chart formation may be present on multiple time frames on a popular municipal bond ETF.

As we are primarily equity managers, today’s Chart Of The Day is a rather rare foray into the world of fixed income for us. That said, the analysis is not necessarily outside of our regular M.O. First off, we are not making a recommendation on municipal bonds. In fact, nothing in these pages constitutes a recommendation to invest in any particular way. In particular, though, we are not espousing the benefits unique to muni bonds. Nor do we consider ourselves in any way to be experts on the structure or varieties of muni bonds. Today’s Chart Of The Day simply points out our interpretation of the price chart of a particular ETF that tracks the muni bond market.

Specifically, the ETF is the iShares S&P National AMT-Free Municipal Bond ETF, ticker MUB. The chart pattern potentially in force on the chart is a “cup-&-handle”. We have discussed this pattern in other posts in the past, including the fact that it typically is considered to be a bullish pattern. What does it look like and why is it bullish? The pattern involves 2 parts, generally showing the following characteristics:

The Cup: This phase includes an initial high on the left side of a chart followed by a relatively long, often-rounded retrenchment before a return to the initial high.

The Handle: This phase involves a shorter, shallower dip in the security and subsequent recovery to the prior highs.

The bullish theory is predicated on the idea that after taking a long time for a security to return to its initial high during the “cup” phase, the “handle” phase is much briefer and shallower. This theoretically indicates an increased eagerness on the part of investors to buy the security since they did not allow it to pull back nearly as long or as deep as occurred in the cup phase. Regardless of the theory, the chart pattern has often been effective in forecasting an eventual breakout and advance above the former highs.

What’s interesting about the MUB chart is that it arguably contains not one but two cups-&-handles currently.

As the chart shows, the larger cup-&-handle spans the past approximate 16 months. The smaller cup-&-handle is contained within the handle of the larger one, spanning the past 3 months. Again, assuming this is an accurate interpretation of the chart, it has bullish connotations for MUB going forward. 

First, the pattern typically resolves itself to the upside, i.e., a breakout in this case above roughly the mid-112 area. How far does the pattern imply the MUB might rally upon a breakout? That is certainly more of an art than science, but various technicians argue for a 50%-100% extension of the range of the “cup”. In this case, the “big” cup ranges from a high around the mid-112′s to a low near 107.50. Therefore, the range is about 5 bucks.

Based on the 50%-100% rule of thumb, a breakout would suggest the pattern would produce an advance of 2.50-5.00 above the top of the range. That may not seem like much, but in the bond world, it is a nice return. This is particularly so considering the fact that this chart is not adjusted for dividends.

No matter the market environment that exists, there are always bullish and bearish-looking setups in the market. Sometimes one needs to look outside of their typical investing neighborhood to find them. In this case, the muni bond chart is currently displaying a potentially bullish pattern -- and on multiple times for that matter. If the typical history of cups-&-handles plays out here, muni bonds may be poised for a nice rally in the near future.

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More from Dana Lyons, JLFMI and My401kPro.

I am sympathetic with the concept of disruption that has taken off in the tech sector — see my earlier essay, In Defense of Disruption as a Cultural Phenomenon. However, I also think it is important to recognize that our social institutions have not evolved by accident. Some of what is labeled as disruption is, in fact, providing solutions to problems that do not exist.

The latter is precisely how I feel about the start-up Neighborly, which garnered headlines this week for raising $5.5 million from Jon Lonsdale’s Formation 8 and Ashton Kutcher’s Sound Ventures. Yes, that Ashton Kutcher. For coverage from someone far more entertaining than I am, readLauren La Capra’s hilarious piece at Fusion.

Of course, it is the job of venture capitalists to sort out the wheat from the chaff. In the case of Neighborly, however, we are talking about managing other people’s wealth through a brokerage firm— and more specifically, highly unsophisticated investors’ wealth — and offering them what is arguably unsuitable investment advice. So whether this turns out to be a financially viable recreational venture for celebrities — and it probably will not — is beside the point.

Artisanal Infrastructure?

I guess it was inevitable that someone would propose artisanal infrastructure investment for millennials. (Hat tip to @dougtee for coining the term.) I mean, someone’s already proposed artisanal stock options. Millennials apparently have a lot of kooky investment preferences. They don’t trust the stock market, so now there is a start-up to pitch them derivatives. They want to be more involved in their community, so now there is a start-up to pitch them micro-munis. With all this money they have to invest, it’s a wonder all we hear about is the mountain of student debt outstanding.

Here’s how Bloomberg described Neighborly back in August:

Many community-interest projects are still funded by traditional sources. When they are, start-ups such as Neighborly are helping individuals play a role. The company, which says on its website it is “democratizing the $3.8 trillion municipal securities market,” aims to allow users to buy portions of a municipal bond rather than the whole thing.

“Most people don’t think to go, ‘Hey, I’m going to go buy a municipal bond,’” says Jase Wilson, the chief executive officer of Neighborly. “It’s about breaking down the minimum denomination on one side so there’s more of a democratic access. It’s about demystifying it.”

Wilson says Neighborly seeks to sell municipal securities through its registered broker-dealer and tries to make it easier for investors to understand where their money is going. He says he hopes the company will help rekindle local involvement in the municipal market, which once created such projects as the Golden Gate Bridge. At the moment, the bond market that millennials’ grandparents invested in is gone.

“They would go buy bonds in their own community for a project they support,” Wilson says. “They would put [the bond certificate] under their bed and clip the coupon, and they would just get some ice cream. It was super local, super hands on, super regenerative.”

They’d clip the coupon and go get ice cream? Isn’t it a little strange that the tech sector would be nostalgic about physical coupons? Once created such projects as the Golden Gate Bridge? Did the market stop financing capital projects and no one told us?

It’s absurd to suggest that the municipal bond market has somehow become “less local” than it was when the Golden Gate Bridge was built. Heck, the Golden Gate Bridge and Highway District, the debt-issuing authorityestablished in 1923 to finance the construction of the bridge, still exists andstill issues debt. There are over 90,000 borrowers in the municipal bond market. Most of them are small governmental entities, and many of their bonds are picked up by local households and businesses that directly benefit from the improvements being financed. This is one of the many reasons why municipal defaults are so rare.

I have said in past essays that the United States is the City on the Hill when it comes to funding infrastructure. No other country in the world has this system of local funding of infrastructure, which evolved historically with the growth and development of our nation and fits our federalist ideals. It is certainly true that procurement structures like public-private partnerships are gaining in popularity, but they are hardly the threat to the multi-trillion-dollar municipal bond market some observers make them out to be. They are an opportunity to expand and diversify the investor base.

All this is to say that the municipal bond market already represents a system of crowdfunding. It is kind of difficult to disrupt crowdfunding with crowdfunding.

From TechCrunch:

Wilson started getting to know municipal bond traders, who were exchanging and issuing the debt that cities need to fund projects. A trader walked Wilson through underwriting and compliance, and then over to a fax machine with stacks of papers and contracts. The trader explained to Wilson that just by switching from corporate to municipal debt, he could double his income without doing any extra work. This was because public city governments ended up with extra layers of fees throughout all of the steps of municipal debt issuance that corporate issuers were more rigorous about holding accountable.

A fax machine. Hahaha. I’d love to know what firm this is.

As someone who has seen literally thousands of municipal bond transactions, I can’t even begin to tell you how false all of this is. First of all, it blows my mind that anyone would suggest that it is expensive to issue bonds of any stripe these days. In an environment where there is too much money chasing too few bonds (thanks to the Federal Reserve and a period of net negative issuance following the Great Recession), issuers hold all of the power. Basically every bond issue has been oversubscribed, even toxic credits. Competition among banks has been intense, and underwriting fees reflect that.

Second, not to point out the obvious to Mr. Wilson, but one major difference between corporate borrowers and government borrowers is that the expenses incurred by governments — including the costs of issuing bonds — is narrowly restricted by state laws and federal tax law. If you came up in a firm that tacked on fees for fun and that is your idea of how the world operates, the securities industry is probably not the ideal niche for you.

Cutting through all the crowdfunding rhetoric and getting to the mechanics, it seems that Neighborly is really only a standard brokerage firm that is marketing its services to (albeit civic-minded) millennials, and trying to persuade issuers of municipal bonds (i.e., governments) to use smaller denominations (rather than the usual $5,000 to $100,000) to accommodate their client base, which has relatively little money to invest but wants to participate in their community.

For top-rated credits, it probably doesn’t matter what denominations an issuer uses, and I think most issuers realize that. The larger denominations can be used to keep firms from marketing risky deals to unsophisticated retail investors (so pretty much Neighborly’s target market), as was the case with Puerto Rico’s last general obligation debt offering. Although I would be skeptical of a government that is especially enthused about placing a deal with the kind of retail investors Neighborly is bringing to the table regardless. That seems like a situation that is ripe for fraud.

Why municipal bonds are generally not suitable for younger investors

Practically speaking, the minimum denomination of bonds is not the limiting factor for investing in municipal bonds. Not even remotely close. The tax status of municipal bonds is. Millennials are not a native source of demand for municipal bonds for a reason — they do not have incomes high enough to benefit from the tax shelter the bonds provide. (For background, see my essay, Why Are Municipal Bonds Tax-Exempt?)

So what does this mean for them as investors? Municipal bonds have lower yields than other investment vehicles (e.g. corporate bonds) because investors are willing to accept lower interest rates in exchange for the tax benefits they offer. I mentioned this to the CEO of Neighborly during a brief exchange on Twitter — that by recommending municipal bonds to relatively low-earning millennials, his firm would basically just be telling them them to give up yield for nothing — and he told me that this was only true now, and these same people would be earning more in the future.

But that’s not how investing works. Usually when someone invests money, they want to make the most money given the amount of risk they are willing to make. Their savings aren’t supposed to be a form of tuition.

On top of that, there are good reasons that firms do not try to put investors with relatively small assets under management into high maintenance (in terms of due diligence) holdings like bonds. There’s no money in it, unless the firm is willing to charge exceptionally high fees, which the client by definition cannot afford. There’s also a lot of risk in compliance and surveillance. I imagine by the end of this venture, Lonsdale and Kutcher will realize they’ve donated to a charity.

So, Puerto Rico defaulted on a relatively minor bond payment last Monday, and it is a truth universally acknowledged that a government default must be in want of an avalanche of hot takes. Although it is difficult to absorb all of the instant authorities out there, these events do provide an interesting opportunity to observe how various money managers form opinions about different securities.

Brian Chappatta’s article, Puerto Rico Shows Perils of Muni Bonds Backed by Empty Promises, quoting a number of market participants and observers hyping the risks of appropriation-supported bonds versus other bond structures, has compelled me to write something about realistic versus sentimental perspectives on bondholder protections.

The plural of anecdote is not data

The article begins:

Municipal-bond investors are learning that when cash gets tight, promises are made to be broken.

Puerto Rico’s default Monday on bonds sold by its Public Finance Corp. underscored the risks of debt backed only by a legislature’s pledge to repay. Two days later, Chicago’s Metropolitan Pier and Exposition Authority’s rating was cut to near-junk from AAA by Standard & Poor’s because Illinois hasn’t appropriated the money to pay its bonds amid a stalemate over the budget.

Unlike with general obligations or debt that has a claim to specific revenue, buyers have little recourse if politicians walk away from appropriation bonds, a $197 billion niche of the municipal market. Vadnais Heights, Minnesota, and Menasha, Wisconsin, have already done so. In bankrupt San Bernardino, California, investors may recover one cent on the dollar.

“Appropriation debt is scarier than people want to think it is,” said Matt Dalton, chief executive officer of Rye Brook, New York-based Belle Haven Investments, which manages $3 billion of munis. He said his firm tends to avoid the securities.

Legislators “have to come around the table and appropriate each year, and as you can see, if they’re not on sound financial footing, you’re taking a lot of risk,” he said.

So S&P formerly rated Chicago’s Metropolitan Pier and Exposition Authority higher than it rates the United States of America, then noticed that (1) Illinois policymakers sometimes have difficulty agreeing on spending, and (2) the bonds are already in technical default — and the news story there is about the underlying debt structure? Come on, the super-downgrade is Onion material, not Bloomberg material.

First of all, there is not $197 billion of appropriation-supported debt outstanding. To arrive at this figure, one would have to count a lot of debt that does not truly fit into this category. I’d submit to you that some of the examples cited in the article do not count.

Second, even if that were true, defaults by issuers like Vadnais Heights — population 12,302 — and Menasha, Wisconsin — population 15,144 — are not exactly terrifying precedents for the marketplace. Both examples are more cautionary tales on economic development projects than an indictment of appropriation-supported debt in general.

One of the key considerations for investors in Vadnais Heights, which defaulted in 2012, should have been that bond proceeds were being used to finance the construction of a controversial, non-essential project. These factors used to be central to credit analysis, and now no one cites them. Why is that?

Did a city with a population slightly over 12,000 need a giant sports complex with two ice rinks and Minnesota’s second-tallest dome, covering a 100,000 square-foot turf field? (“If you build it, they will come. If you build it, they will come…”) I don’t know about you, but I am not particularly surprised by this default and more than a little reluctant to lump this example in the projects governments typically finance with general fund dollars.

Menasha defaulted on bond anticipation notes that the city issued in 2005 and 2006. Bond anticipation notes are a form of short-term debt that are supposed to be taken out through the later issuance of long-term debt. The primary investors were a Maryland retirement complex, a life insurance company, and a community bank.

These investors ultimately ended up with higher recoveries on their notes than the general obligation bond investors Chappatta cites later in the article. So Menasha is actually a counterexample, not an example, of Chappatta’s argument here.

Menasha’s largest employers are paper mills. In order to help the large corporations that operate these mills cut costs, the city decided to convert its utility from an electric plant to an industrial steam plant, thereby reducing the cost of power. (“If you help us cut costs, we will not downsize employment and your little village will survive.” Probably how discussions went, no?) The project was supposed to cost $12.7 million and be completed within one year, but was plagued by cost overruns. The city ended up borrowing $40 million, including general obligation bonds and the notes. Given the scope of cost overruns and mechanical problems with the facility, the city ended up not issuing bonds to take out the notes and closing the plant.

The story does not end here though. Menasha’s creditors sued the city and the case wound its way through the courts. It was eventually settled for $17.5 million of the $22.8 million owed. This is more (percentage-wise) than the voter-approved, unlimited tax general obligation bondholders in Detroit received in bankruptcy.

Incidentally, the settlement was funded through a sale-leaseback agreement with WPPI Energy and Menasha Utilities, not city tax dollars. Detroit had similar options, but Jones Day decided to turn the city into a fee machine rather than seriously consider them.

I could cherry-pick revenue bond deals that did not end well for investors (excluding hedge funds that specialize in distressed debt) as Chappatta has done with appropriation-supported debt in this article. Remember Jefferson County, Alabama? Or Harrisburg, Pennsylvania? These were not exactly small transactions, either. And yet folks like Mr. Dalton aren’t coming out of the woodwork swearing off revenue bonds forever. Why is that?

I also find it interesting that Chappatta uses San Bernardino considering paying its pension bondholders a penny on the dollar as an example.Stockton similarly wiped out Franklin in its bankruptcy too — a secured creditor.

“Legal protection” doesn’t mean what you think it means

It makes zero sense to make sweeping generalizations about the relative safety of debt based on the specific kind of pledge involved alone. And yet this is how the majority of folks in the municipal bond market think. What Chappatta is suggesting in this article fits the traditional way of looking at risk that old-school municipal bond attorneys frequently lay out in the press. But they are not the ones litigating Chapter 9 cases now, and that is a point that cannot be emphasized enough. There is a new landscape and even general obligation bonds involve very real risks in some distressed situations.

An investor’s first question should be “what kind of legal regime am I operating under here?” The legal and political contexts in which your bonds are issued are what make your rights and remedies relevant. If there is a lesson to be taken from the recent spate of financially challenged municipalities, this is it. General obligation debt is not the same security in different states depending on whether those states authorize Chapter 9, where it is treated as unsecured debt absent a statutory lien (which very few of the states that authorize bankruptcy offer) and may be adjusted.

Chapter 9 cases are now being litigated by corporate restructuring attorneys who have far less sentimental regard for general obligation debt than attorneys who specialize in municipal debt and, it seems from the article, many institutional money managers. The reason recent bankruptcies have been devastating for bondholders is that corporate restructuring attorneys will bulldoze anything and everything, and the law permits this. By the way, many of these attorneys are advising Puerto Rico’s government and Atlantic City.

There is also a big difference here in whether you are talking about debt issued by a state or local government, both with respect to structure and risk. Local governments, as political subdivisions of state governments, are constrained by state law regarding how much debt they can assume and how much and which taxes they may levy. Tax revenue may also feed into the same fund along with funds for operations, pensions, etc. (Chicago is an excellent example of this, in fact.) This can make a tremendous difference in the amount of risk involved.

This is where it gets strange to swear off a class of debt for its own sake, especially given the diversity of appropriation-supported debt. Which would you rather have: (1) Appropriation-supported debt financing an essential government property issued by a community that has broad ability to raise revenues or (2) general obligation bonds issued by a community subject to a tax cap? (1) Appropriation-supported debt in a state that does not authorize Chapter 9, where a potential default can be litigated aggressively in state courts, or (2) general obligation debt in a state that does authorize Chapter 9, where the borrower has access to a convenient legal shield? (1) Appropriation-supported debt issued by a government with no pension problems or (2) general obligation debt in a state where pensions are severely underfunded but have constitutional protections? It’s a big, big universe.

For many state and local governments that issue appropriation-supported debt, there is solid political will to repay the debt, hence the scarce defaults. Debt service may even be legally considered a continuing appropriation and thus insulated from late budget adoption (contra the Illinois example in the article). When budgets are not adopted for some reason or another, there are usually legal determinations about which government expenditures do and do not continue to be paid, and these are not the same thing from government to government. (Except in Illinois, where they aren’t even the same from budget cycle to budget cycle — ha.)

Using an appropriation-supported structure as opposed to a general obligation structure is not generally intended to provide a deliberately weaker security from the government’s standpoint. It can also be a political expedient to circumvent a constitutionally or statutorily required referendum. Many governments have extraordinarily well-established debt programs and legal protections that can be pursued in state courts. These could even include liens on a specific piece of property. That may not be the same thing as getting a court order to levy taxes, but it is not an “empty political promise” either. It is a remedy with quantifiable economic value.

How does one know these things exist? Well, relevant state law is usually summarized in offering documents.

Finally, not to point out the obvious, having debt issued under other structures/resolutions is its own incentive to appropriate funds for most borrowers. A good example of this is Rhode Island deciding to stand behindits embarrassing offer of support for the 38 Studios project.

Back to Chappatta’s article:

Detroit’s $18 billion bankruptcy illustrated the differing legal protections for investors. Buyers of its certificates of participation, which had neither the city’s taxing power nor specific revenue streams behind them, recouped 12 cents on the dollar, according to a report this week from Moody’s Investors Service. Holders of its general obligations got six times more.

Chappatta is only citing the unlimited tax general obligation bondholders, who recouped 74 cents on the dollar — and I guarantee you they felt completely and utterly screwed, not delighted, about it. The limited tax general obligation bondholders — who, last time I checked, were still general obligation bondholders — recouped only 34 cents on the dollar. Most municipal bondholders would be horrified by these recoveries.

Syncora, the insurer on the city’s pension certificates, also settled for physical assets in the city that may appreciate over time. Syncora is no stranger to project finance (Syncora acquired the operator of the Detroit-Windsor tunnel from bankruptcy), and made a somewhat clever play here in picking up assets related to those the insurer already held.

Importantly, these recoveries are the products of negotiated settlements between the bondholders and the city, which are both arbitrary and path dependent. Negotiated settlements do not say anything about legal protections. A legal precedent regarding the status of the bonds could only be created through a ruling that is upheld by an appellate court. Even then, it would be difficult for it to translate state-to-state.

Detroit’s bondholders were perversely subordinated to the city’s swap counterparties (!), which were treated as secured debt only because doing so was useful to Jones Day to have a cram down option in negotiating with bondholders and pension beneficiaries. The city could have chosen to challenge the swap counterparties’ status, seeing as how using casino revenues to secure interest rate swaps was not exactly a permissible use of casino revenues under state law. Then bondholders’ recoveries theoretically could have been higher. Such were their legal protections.

Bondholders were also practically subordinated to pension benefits, which were treated as another form of unsecured debt but arbitrarily had much higher recoveries. Such were their legal protections.

Had any of the parties settled earlier than the others, they could have received a higher amount. Had the grand bargain not have been involved, they could have received a higher amount. Had the judge not been a populist that often sided with pension beneficiaries, bondholders could have received a higher amount. The city could and often did play all groups of bondholders off of each other in the negotiation process. Theoretically, all bondholders could have been wiped out and stakeholders could still be fighting.

The bonds were the first to take the hit in Puerto Rico, where the government is reeling from $72 billion of obligations. Faced with a growing cash crunch, the legislature didn’t provide funds to cover bonds the commonwealth’s Finance Corp. sold to help keep the government afloat. When $58 million of interest and principal was due Monday, it paid just $628,000.

Let’s be intellectually honest here— Puerto Rico is already not making payments on its general obligation bonds by suspending the set-aside payments that it should be making.

The set-asides were the reason Puerto Rico’s $378 million July 1st general obligation payment was made as scheduled even though the territory was in the middle of a liquidity crisis — the trustee already had the funds on hand to make the payment.

From Puerto Rico’s perspective, resources due under both financial commitments have been diverted to operate and bondholder claims have been politically subordinated to services.

From the Bond Buyer:

Until early July a 1976 law required Puerto Rico’s government to equally set aside its interest and principal general obligation debt service on a monthly basis. The 1976 law required the Puerto Rico to set aside each month one sixth of all interest coming due in the coming six months. It also required the commonwealth to set aside monthly one twelfth of all principal coming due in the coming 12 months. The funds were set aside in a redemption fund.

In early July Gov. Alejandro García Padilla signed a measure annulling the 1976 law.

On Monday Puerto Rico posted a statement on the Electronic Municipal Market Access site that said it had “temporarily suspended” the set asides.

When the idea of stopping the set asides surfaced in June, Puerto Rico Representative Rafael Hernández Montañez told The Bond Buyer that Puerto Rico would make its GO payments. Hernández Montañez is the president of the Puerto Rico House of Representatives Treasury and Budget Committee and a member of the Popular Democratic Party with García Padilla.

Since then, Puerto Rican officials have not been as definitive that Jan. 1's $375 million GO payment will be made. After the governor signed the measure allowing the set asides to be suspended, his office sent out a press statement saying that, “the suspension of these deposits does not imply a breach with the bondholders on the date of payment.”

In mid-July Puerto Rico Director of the Office of Management and Budget Luis Cruz Batista told the El Vocero news site that the GO payment was not assured. Earlier this week, Melba Acosta Febo, the president of the Government Development Bank for Puerto Rico told El Vocero that she couldn’t guarantee the GO payment but that the government was working to improve the central government’s liquidity so it could make the payment.

“We recognize the GO’s priority over other debts and its difference from other debts, but we must also recognize that there is a duty of the state to maintain health services, education services, and some security to our people — we must look at those things,” El Vocero quoted her saying. “So it is a part of a negotiating process, in which both parties are agreeing to modify certain terms and in which conditions of some payments are very difficult.”

Puerto Rico’s general obligation bonds do have strong legal protections that range from constitutional provisions to clawing back revenues from other public entities. The wild card for Puerto Rico is the question I said bondholders need to start with, which is “what kind of legal regime am I operating under here?”

Section 8 of Article VI of the Constitution provides that the public debt of the Commonwealth will constitute a first claim on the public resources. A constitutional protection is obviously a very strong legal protection, but it remains unclear what a court would do if general obligation bond payments came into conflict with basic government services or how other constitutional provisions might be interpreted if the Commonwealth used them strategically. This could work out poorly for investors in the event of default (depending upon where they jumped in, of course) or it could work out very well.

So what happens in the event of non-payment? Well, it depends on when the bonds were issued.

Puerto Rico has some general obligation bonds (dated March 17, 2014) that are governed by New York State law. In the event of nonpayment, bondholders can sue the Commonwealth to enforce the provisions of the bonds in New York courts or US federal courts sitting in the borough of Manhattan; the City of New York, New York; Commonwealth courts; or US federal courts sitting in San Juan, Puerto Rico. Puerto Rico has also waived sovereign immunity for these bonds. Of course, the fact that bondholders have the flexibility to decide which court to bring suit in doesn’t mean the court is required to hear the suit. Fun, right?

Holders of Puerto Rico’s other general obligation debt would have to bring suit in San Juan. These bonds could potentially be subject to sovereign immunity, which restricts the scope of legal actions and monetary damages involved. Puerto Rico’s general obligation bonds are not subject to acceleration, a remedy found in other forms of debt.

The lack of a clear legal regime is further complicated by the fact that Puerto Rico owes money to a lot stakeholders, who will all be asserting their rights in a web of suits against the government and each other across jurisdictions. This is not a place devoid of investment opportunity, but to believe there is a clear hierarchy among all of these stakeholders in terms of potential recoveries is naive.

Political risk works both for and against bondholders. In situations like 38 Studios, there was intense political pressure to make good on a promise to appropriate funds for debt used to finance a bad project just to maintain the state’s good credit — even though those funds could have been directed toward more responsible priorities from taxpayers’ perspective.

Where negative political risk exists, it can be divided into soft and hard risks. Soft risks are usually one-off events, and I daresay disproportionately tied to economic development. You have a government where officials long gone endorsed a project that didn’t perform and now current officials do not want to support it. These risks are actually pretty easy to predict. If a government has to finance a project that should be producing revenue on its own, it is probably a bad deal. You’re welcome.

Are you ready for the next crisis?  We have weathered Greece leaving the Euro, and rising interest rates.  Well, actually neither of those things have happened.  But Puerto Rico did actually default Monday on a debt payment.    Will this be the straw that breaks the Muni market?  On first look, no, not at all.

The weekly chart above of the Municipal Bond ETF, $MUB, shows that there was some trepidation when the thought of Puerto Rico defaulting surfaced earlier this year.  But since early June the price has been moving higher.  

The RSI turned up at the start of June as well.  And it is now firmly into the bullish zone.  The other momentum indicator, the MACD, just printed a bullish cross two weeks ago, also supporting further upside.  How far can it go?  On a broad scale the ETF is breaking a descending triangle, giving it a target of 111.50.  but the longer move higher into that triangle consolidation suggests that a move to 120 is in the cards.  

So Puerto Rico defaults and the Muni market yawns.

The Chicago Tribune published a self-recommending article over the weekend about Chicago Public Schools’ pending cash crisis. Information in the article — which was provided by Ernst & Young— directly contradicts claims officials made in investor presentations and offering documents when the school system issued bonds only two months ago:

To pay the huge tab owed to the Chicago Teachers’ Pension Fund, make payroll and cover other costs, the nation’s third-largest school system would have to drain its checking account, max out its line of credit and burn cash set aside to pay other debts, according to outlines of school finances presented in city documents.

If CPS resorts to these steps, the district has no clear way to close next school year’s $1 billion budget gap without teacher layoffs, increased class sizes and perhaps even a late opening of schools …

Even if CPS wins concessions from the City Council, state lawmakers and the [Chicago Teachers Union], the district won’t be able to close its annual $1 billion budget gap, according to the May 22 report by Ernst & Young, which spent four weeks meeting with school finance officials and analyzing budget documents. The report shows that even with a capital improvement tax, a separate, even-larger property tax increase, additional state aid, increased state funding of teachers pensions, concessions from the CTU and $150 million worth of budget cuts, CPS would still face an annual $350 million shortfall.

According to the Chicago Tribune, the investor presentation indicated that CPS would have $227 million left in its operating account at the end of the fiscal year, but Ernst & Young estimates that the school system could be out of cash as early as this summer. Prior to issuing the bonds, the Chicago Board of Education (CBOE) replaced Moody’s with Kroll for the sake of having three rating agencies willing to give the bonds investment-grade ratings.

This is one of several examples of nonsensical divergence in ratings of late. S&P rated the City of Chicago’s sales tax-supported debt AAA, when Moody’s has it at junk. I agree with the latter assessment, seeing as how the revenues are not legally segregated from the city’s general operating fund. This is the most basic bondholder protection, and it is absent. For an issuer in Chicago’s financial situation, this should be a major concern.

Another strange example is Wayne County, Michigan, which is currently under review by Michigan’s Treasury Department for financial emergency status. Wayne County could potentially go from financial emergency to consent agreement to emergency manager to Chapter 9 within a short period of time — for Detroit, this process took less than a year and was aggressively driven by the state. Per Municipal Market Analytics, S&P gave Wayne County an investment grade short-term rating (SP-1), while all three rating agencies have junk ratings on the county’s long-term debt. What’s up with that?

Another interesting tidbit from the Tribune article is that CPS has reportedly paid off some of the $228 million of swap termination payments it owes to bank counterparties, which CPS used in conjunction with previous bond issues. CPS declined to disclose to the Tribune the dollar amount of those payments because it could potentially jeopardize on-going negotiations.

These developments should concern CBOE bondholders for two reasons. First, the swap termination payments are likely to eliminate the school system’s $174 million debt service stabilization fund in its entirety. The CBOE had established this fund as a buffer to make debt service payments in the event that budgeted revenues do not materialize. However, those funds were not specifically pledged for the repayment of CBOE’s bonds and the board has never covenanted to maintain the fund at any particular level. Now the fund is being used as a source of liquidity for the swaps. This is a management decision that pits bondholders’ interests against those of its swap counterparties, and bondholders have lost.

(Pledges, covenants, legal segregation — these things matter!)

The second reason bondholders should be concerned is that, in some cases at least, the variable rate bonds they are holding do not involve a credit facility typically provided by a commercial bank. This means investors are directly exposed to CBOE’s credit in the event of a failed remarketing.

As I described in my earlier essay about ratings shopping, The Potential Insolvency of Chicago Public Schools and the Stickiness of Credit Ratings, CBOE bonds have a bizarre auction rate securities-ish structure. And — for no reason that I can figure out—CBOE continues to use this structure even though it has unraveled spectacularly.

Typically, when an issuer uses a variable rate structure, the issuer obtains some sort of credit facility to backstop the debt in the event of a failed remarketing. A failed remarketing occurs when there is not sufficient demand for the bonds. When a credit facility is in place, the debt does not carry the rating of the issuer. Instead, the debt carries the rating of the financial institution providing the credit facility.

I am assuming that CBOE could not locate a commercial bank that was willing to backstop its debt, and thus the liquidity/credit risk has been transferred to investors. CBOE has to pay penalty interest rates upwards of 9% on the debt, which only exacerbates its financial problems and decreases its ability to repay bondholders.

According to the Tribune, the use of this debt structure and the accompanying swaps was pushed by CBOE President David Vitale, a former vice-chairman of Bank One. Vitale will likewise be providing advice on how the school system will address a situation where it will be left with a large deficit even under the best of circumstances.

I expect that Chicago Public Schools will prove my thesis that a governmental entity can afford dysfunction or an unconventional debt structure, but it can’t afford both. An unconventional debt structure will require the use of resources that would otherwise prevent dysfunction from turning into a financial catastrophe.

Update 6/23/15: Yvette Shields at the Bond Buyer told me that Chicago Public Schools is now seeking a $200 million line of credit to address its deficit this year and $935 million to address its deficit next year. The school system’s deficit is expected to balloon by almost $1 billion more at the end of fiscal year 2016.