As spreads on bonds from the recent, Detroit Water and Sewer, Chicago Water and Chicago Wastewater deals tighten, some analysts are saying the credits might not be as safe as investors think.
Investors flocked to the deals because the bonds' association with the two fiscally troubled cities boosted their yields, while their ratings remained higher than the cities' general obligation bonds, traders said. The skeptics said these credits offer higher yields for a reason.
"The problem with these issuers are that they are financially challenged especially in those locations," Dan Heckman, senior fixed income strategist at U.S. Bank, said in an interview. "They are in an area of the country that is economically challenged and will remain so for the time being, even though [the cities] are making great strides."
The $1.8 billion Detroit Water and Sewer deal in August and the $293.4 million Chicago Wastewater deal in September both were oversubscribed, and the $371.05 million Chicago Water deal in September also generated investor interest.
Yield Grab Strategy
Paul Mansour, managing director and head of municipal credit research at Conning, explained the strategy of buying bonds sold by an essential service issuer linked to an economically troubled area in an interview.
The "theme of our [investment strategy] is to look for solid essential service revenue bonds in areas that are a little distressed to get a little bit of yield," he said.
He said his group had been trying to purchase the Chicago Water bonds, though it was unable to due to the high demand for the credits. The bonds "provide a little extra bonus for the investor" in terms of yield, he said, calling them "the best credit" in the Windy City.
"It's a fundamentally improving credit, and offers enough insulation from the city of Chicago to offer enough value for the rating," he said. "The pension costs are, relatively, 2% to 3% of total expenditures. Right now our general investment strategy is looking for credit with high capital and low human resource costs; this fits the bill. The percent of expenditures that go to personnel is relatively low versus other credits, and revenues fairly stable."
In an Aug. 26 interview, the day the Detroit Water and Sewer deal was priced, a trader in New York said that many buyers of the Detroit bonds were purchasing them because they preferred owning essential service credits instead of the city's GOs because then "at least you know where your money is going."
He also said investors were grabbing up the bonds because they offered some yield in a low yield environment, and that many were discussing buying the uninsured over the insured bonds.
"Insurance protects the bonds," he said. "There are basically two types of buyers, those that understand the underlying ratings and understand the bankruptcy court, and want to buy them naked. And there are the others who want them insured so they have backing in case something does not go well. In this environment, it makes sense to buy the bonds uninsured because people are hungry for yield, and if you can get a rating people will buy it. Everyone is clamoring for yield right now."
Anthony Valeri, fixed income and investment strategist at LPL Financial said in an interview he's seeing a subtle shift already toward essential service credits.
Detroit and Chicago Essential Service Spreads Tighten
The investment in these credits from essential services issuers associated with fiscally challenged cities seems to be paying off, as spreads of bonds from the three issuances to Municipal Market Data's triple-A curve are tightening across the board.
A sample of five of the most actively traded Detroit Water and Sewer CUSIPs Markit provided the bond buyer showed spreads have all tightened since the bonds' first trading day on Aug. 28. The spread on 5s of 2044 local government loan program revenue's bonds narrowed by as much as 97 basis points on the most recent trading day, Sept. 18, according to EMMA. The 5s of 2034 water supply bonds' yield tightened by as much as 45 basis points by Sept. 3, and the 5s of 2035 water supply bonds spread came in by up to 38 basis points as of Sept. 11, when they were last traded.
The 5s of 2044 local government loan program revenues tightened as much as 38 basis points as of Sept 11, and the 5s of 2031 local government loan program revenues came in as much as 140 basis points as of Sept. 4.
A sample of three of the most actively traded Chicago Water credits provided by Markit spreads also all tightened from their first trading day on Sept 11. The 5s in 2033's spread constricted as much as seven basis points as of their latest trading day on Sept. 12, according to EMMA. The 5s in 2030 tightened up to seven basis points, also as of Sept. 16, and the 5s of 2044 came in by 18 basis points when they were most recently traded, on Sept. 23.
The Chicago Wastewater bonds' spreads have also have mostly tightened, though the bonds first started to trade on Sept. 17 so the constriction is less than the Detroit Water and Sewer and Chicago Water bonds. For example the spread on Chicago Wastewater 5s of 2044's tightened up to one basis point, as of Sept. 23. The 5s of 2039's spread came in by as many as five basis points when they were last traded on Sept. 18.
Issuers Potentially Unstable
Analysts said the main reasons investors should be cautious are that the settlements Detroit and its Authorities are involved in are still ongoing, and that Chicago's pensions issues might not be resolved as soon as investors predict.
Ashton Goodfield, Head of Municipal Bond Trading for Deutsche Asset & Wealth Management, pointed to the issues around the "impaired" outstanding water and sewer bonds under the city's debt adjustment plan.
"There were certainly expectations there would be no impairment regarding the Detroit water and sewer, but we did not know until a couple weeks ago that it was going to be that way," she said. "For a while the Detroit water and sewer authority talked about calling bonds before their call date, calling them at par."
In Chicago, "I have not seen much progress on its pensions [issues], and that still needs to be addressed," said Anthony Valeri, fixed income and investment strategist at LPL Financial.
Heckman said that he does not know if these are good credits for buy-and-hold investors.
"I think there are still challenges out there, and you have to be selective about what credits you look at from a buy-and-hold standpoint," he said. "For buy-and-hold investors, look at high credit quality bonds."
