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COURT STREET GROUP Research LLC
August 25, 2017
THE WEEKLY MUNICIPAL PERSPECTIVE Executive Summary: Managing Partner, George Friedlander, notes that municipals edged ahead of Treasuries this week on continued light supply, lower refundings and a continued shortage of yield paper making investors gobble up any paper that is out there. He also details the implications for munis with the recent Tax Reform proposals that have been discussed on Capitol Hill. As we note, it seems that Tax Reform remains on track, despite political squabbling between the Administration and Congress. It also seems clear that Republican lawmakers are looking for at least one big win, and that Tax Reform provides the best shot to achieve that. In our Credit Focus, Partner, Joseph Krist, gives a credit overview of next week’s largest deal, a $2.5 billion GO offering out of California; A look at lower-denomination bond deals, specifically a Vermont GO deal priced this week, and why they benefit issuers’ attempts at attracting traditional retail investors; Pension reforms in Jacksonville, FL are a credit positive; St. Louis Comptroller’s fight with the NHL; MLB tries for bonds for the minors; The first post-MCDC SEC fine; A P3 in Washington, D.C. is deemed taxable; and, Santee Cooper defers rate action, a credit negative.
MUNIS MARKET EDGED AHEAD OF TREASURIES ON VERY MODEST SUPPLY: by George Friedlander, Managing Partner
10-Yr AAA Muni to UST (Source: Bloomberg) 2.8
2.6
2.4
2.2
2
With refunding volume continuing to be extremely modest for reasons we discussed last week, the muni market remains firm on extremely modest supply. Issuance over the past two weeks in the aggregate totaled right about $10 billion. Year-to-date issuance continues to fall further behind 2016 levels. At the end of July, issuance was down 13.2%. By August 25, the decline versus last year had increased to 14.5%. With supply so tight, available paper is being gobbled up pretty quickly as it comes to market. And, credit spreads remain tight, given the continuing shortage of yield paper. As we have noted, we believe that new-money issuance, up a couple of percent year-to-date by late August, would probably increase further with more certainty about 1.8
1.6
1.4
1.2
1 5/2/16
6/2/16
7/2/16
8/2/16
9/2/16 10/2/16 11/2/16 12/2/16 1/2/17 MUNI 10YR
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2/2/17 3/2/17
4/2/17
5/2/17
6/2/17
7/2/17
8/2/17
UST 10YR
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where any Federal infrastructure bill is headed. As of now, the answer seems to be “nowhere,” and if that is the case, state and local issuers may begin to pick up the pace a bit on their own. Supply next week is about $6.9 billion and we highlight the largest deal, $2.5 billion of California GOs as an example of how credit compression and the general positive investor sentiment over California’s economic outlook have allowed the state to see its 10-year GO spread tighten by 23 basis points since it last came to market. Lipper first reported outflows of $635 million from municipal bond mutual funds but then corrected the figure to actually $750 million of inflows.
AAA 30-Yr Muni to UST (Source: Bloomberg) 3.5 3.4 3.3 3.2 3.1 3.0 2.9 2.8 2.7 2.6 2.5 11/30/16
12/31/16
1/31/17
2/28/17
3/31/17 30yr AAA Muni
4/30/17
5/31/17
6/30/17
7/31/17
30yr UST
As we discuss below, it appears that despite the ongoing political “noise” in Washington, a Tax Reform proposal may be taking shape. And, if that is the case, muni market participants need to keep close track of the provisions that would affect marginal tax rates.
10-Yr AAA Muni to UST (Source: Bloomberg) 2.8
2.6
2.4
THIS WEEK’S NEW DEALS FROM AROUND THE COUNTRY: 2.2
2
1.8
1.6
1.4
1.2
1 5/2/16
6/2/16
7/2/16
8/2/16
9/2/16
10/2/16
11/2/16
12/2/16
MUNI 10YR
1/2/17
2/2/17
3/2/17
4/2/17
5/2/17
6/2/17
7/2/17
UST 10YR
$2.5 billion of various purpose general obligation bonds for the State of California, Aa3/AA-/AA-. Goldman Sachs & Co. LLC is head underwriter. The deal is set to price for retail Monday with pricing for institutions Tuesday. $950 million of AMT priority subordinated airport facilities revenue bonds for the City of Orlando, A1/A+/A+. RBC Capital Markets will head the deal that is set to price on 8/29. $558 million of State of Illinois clean water initiative revolving fund revenue bonds for the Illinois Finance Authority, NR/AAA/AAA. Bank of America Merrill Lynch will lead the deal that will price for retail on Monday and on Tuesday for institutions. $308 million Marshfield Clinic Health System, Inc revenue bonds for the Wisconsin Health & Educational Facilities Authority, NR/A-/A-, Bank of America Merrill Lynch is head underwriter and the deal is set for 8/29. $107 million of Magnolia Power Project A Refunding revenue bonds for the Southern California Public Power Authority, NR/AA-/NR. Goldman Sachs & Co. LLC will head the deal that is set for 8/31.
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August 25, 2017
Current proposals on Tax Reform suggest a likely dramatic bear flattening of the muni yield curve, if enacted. There appears to be considerable additional information available as to where Tax Reform is headed, based upon information coming out of the tax writing committees and their staff. In particular, an article in Politico dated August 22 laid out a considerable amount of their thinking so far. The article can be found here. We have been able to confirm significant portions of the construct as suggested in the Politico article, and extrapolate from there in terms of potential implications for the municipal bond market and for state and local governments. Our perceptions are summarized here, and then described in greater detail in the following sections. First, it seems that Tax Reform remains on track, despite political squabbling between the Administration and Congress. It seems clear that Republican lawmakers are looking for at least one big win, and that Tax Reform provides the best shot to achieve that. Second, Democrats are likely to fight any such bill on the grounds that it seems likely to largely benefit high-income individuals, but at this point that any such counter-arguments will do little more than limit the scope of the legislation to a greater or lesser degree, rather than foiling passage of Tax Reform outright. Most observers put an target period for enactment in the first quarter of 2018.
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Third, while treatment of munis is at a level of detail that has not yet been discussed, we remain relatively confident that little or nothing will be done to reduce access to the tax-exempt market. However, as we discuss in more detail below, that conclusion if correct, would not mean that state and local governments would end up unscathed. In our view, two main factors would hurt both munis and state and local governments. The first is the strong likelihood that marginal tax rates for potential buyers of munis could be cut rather sharply, requiring an upward adjustment in muni yields to maintain their competitiveness against taxable debt. As we note, the impact of such a shift would be much greater on short to intermediate municipals, but we expect that muni yields all along the curve would be pushed higher: a classic “bear flattener.” In addition, the revenue side of the state and local government ledger would likely come under at least some pressure if deductibility of state and local taxes were to be eliminated, and the mortgage interest deduction were to be capped, as currently seems planned. We also discuss this briefly below. Why we are particularly concerned about tax rates under Tax Reform, in terms of the benefits of the tax exemption. We have discussed the potential effects of changes in tax rates and their effect on the muni market a number of times, but felt that it would be useful to “re-litigate” these concerns in light of what we believe we can ascertain from the information contained in the Politico story and other sources we have contacted in recent days. There are likely changes from current law that we can identify with some confidence, and then others that are more or less uncertain or speculative. We identify each of these below, including our sense as to how likely the are to be included in a Tax Reform bill, if one is enacted, and the potential impact on muni demand. 1 Reduction in the corporate tax rate. We are hearing that a reduction in the corporate tax rate to roughly 23-27%, from the current level of 35%, is almost certain to be included in Tax Reform. There is strong, broad-based support for a drop in the rate to a level which is perceived to be more competitive with those in other developed nations. The negative impact on demand for munis—or more accurately, the shape of the demand curve, would be significantly greater at a 23% tax rate than at a 27% rate, but in either case, muni yields would have to be somewhat higher on a relative basis for munis to compete with corporate bonds on an after-tax basis after a tax rate cut, than they are currently. 2 Reduction in the tax rate for pass-through entities. Pass-throughs include a number of kinds of businesses for which no taxes are paid at the corporate level, but for which net income is passed through to the owners, who then pay taxes at the applicable rate. These entities include partnerships, limited liability corporations and Subchapter S corporations. Under current law, recipients of income from a pass-through pay taxes at their ordinary income tax rate. Proposals to reduce the tax rate on income from pass-throughs is focused largely on “small businesses,” not yet well defined, and the proposed tax rate has varied wildly from one proposal to the next. President Trump had one proposal which would reduce the tax rate to as low as 15%, but that appears to be completely off the table. What we are hearing now is that the tax rate will likely be the same as that on corporations—i.e., 23-27%—or very modestly higher. In any event, this would be a very sharp drop in the maximum tax rate for individuals who receive income from pass-throughs, versus the top 39.6% rate under current law—a Court Street Group Research
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decline of as much as 12.6 to 16.6 percentage points, perhaps slightly less. Clearly, a drop in effective tax rates that large would induce many high-income individuals to seek to receive income as part of a passthrough, and for individuals who can accomplish this, relative yields on munis would have to go higher than they are under current law in order to compete with corporates on an after-tax basis. We view a cut in the maximum tax rate on income from passthroughs to a rate very close to the new corporate tax rate as highly likely. 3 Treatment of taxable bond interest. We continue to hear from a number of sources, including the Politico article, that a whole or partial elimination of the deductibility of corporate bond interest to the issuing corporation is being considered. Every proposal we have seen that eliminates the deductibility of interest for corporations has been accompanied by “capital income” treatment for interest earned by individuals— taxable bond interest, along with dividend income and capital gains, would be taxed at half the maximum income tax rate. This would be radically different from current law, under which dividends and capital gains are taxed at a maximum rate of 20%, plus an additional 3.8% surtax applies on net investment income for taxpayers with adjusted gross income (AGI) over $200,000 (single filers) or $250,000 (married filing jointly)—a maximum 23.8% rate—versus a maximum tax rate on ordinary income, including taxable bond interest, of 39.6%. We are assuming that under tax reform, the 3.8% surtax would likely be eliminated. There is no way to know how corporate interest would be treated if the deductibility were only partially eliminated, but the worst case scenario in terms of competition with munis would be a new tax rate on all taxable bond interest of 17.5%, versus a current maximum rate of 39.6% plus 3.8%, or 43.4%. Note that the whole or partial elimination of deductibility for corporations only applies to corporate debt, but proposals on capital income treatment would apply to all taxable interest, including Treasuries, agencies, mortgage-backed securities, and even the interest paid on the $9.2 trillion of outstanding CDs and savings accounts. This is, we expect, a very big deal. It would essentially gut the value of the tax-exemption to individuals, if the alternative is buying corporates or other vast amounts of other taxable debt taxed at only 17.5%. 4 Elimination of deductibility of state and local taxes, and a portion of mortgage interest. We expect that both of these provisions will be included, and both would put at least modest downward pressure on state and local taxes. Elimination of deductibility of state and local taxes would increase the maximum effective tax rate on state or local income or property taxes by a factor equal to 1/(1 minus the federal tax rate.) In other words, an 8% state tax for an individual who itemizes would currently cost 8% (1-39.6%), or 4.32%, in the maximum Federal bracket. Without deductibility, it would cost the full 8%, putting pressure on a state or local government to lower their tax rate. A partial elimination of the mortgage interest deduction would likely put some downward pressure on the value of homes, thereby reducing property tax collections by some as-yet unspecified amount. 5 Another consideration not yet dealt with: potential elimination of the Alternative Minimum Tax. It would seem likely, although it has not yet been fully discussed, that any full-blown tax reform bill would eliminate the alternative minimum tax for both individuals and corporations. The impact of such a change for municipal bonds would be negligible, except that interest on private activity bonds would no longer be treated less favorably than that on governmental bonds.
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Why the key changes would result in a bear flattening of the municipal yield curve. The bottom line: a combination of lower corporate/pass-through tax rates and treatment of taxable bond interest as capital income would severely reduce the value of the tax-exemption, particularly on short to intermediate muni bonds. It would thus put upward pressure on muni yields, again with the greatest impact felt on short to intermediate paper. Let’s take a look at why this would be the case. Currently, the ratio of double-A muni yields to double-A corporate yields is roughly 52% in 2 years, 54% in 5 years, 65% in 10 years, and 81% in 30 years. The ratio of triple-A muni yields to Treasury yields is roughly 65% in 1-5 years, 87% in 10 years, and 98.3% in 30 years. If the proper comparison were versus Treasuries, then only shorter munis would be particularly vulnerable —munis simply don’t yield enough at proposed pass-through or capital income tax rates at the 65% ratio which prevails in the 1-5 year part of the yield curve. At the 87% ratio on 10-year paper, muni yields would appear to only be modestly too low, and at the 98% ratio on the long end, prevailing muni yields might be sufficient—if that were the proper comparison. Unfortunately, in our view, it isn’t the proper comparison. Munis tend to compete with corporate bonds on an after-tax basis, NOT Treasuries. This, the remarkably low muni/corporate yield ratios that currently exist would have to go considerably higher versus the 52-65% that currently exists in comparison with corporates in 1-10 years, if effective tax rates under capital income rules were to be as has been considered and described above. An 83% ratio the long end would probably also be too low, given factors like noncallability on corporates, but the amount of upward pressure on muni yields would be far less severe than on short and intermediate paper. So, the bottom line is that when compared to corporate bond interest taxed at a very low rate under tax reform (i.e., including capital income treatment), short and intermediate muni yields would have to go sharply higher, and long-term yields would have to go moderately higher, a classic “bear flattener.” Even if rules for corporate bond interest aren’t changed, we expect that if corporations and pass-throughs face a tax rate of 25% or so, short and intermediate muni yields would have to go significantly higher, although the effect on longer paper would likely be fairly modest—albeit still negative. In any event, tax treatment under the proposed changes being considered will have to be tracked very closely as proposals wend their way through the Congress—assuming that they do.
CREDIT FOCUS: by Joseph Krist, Partner CALIFORNIA COMES TO MARKET WITH $2.5B GOs The State of California is planning to issue $800 million of new-money general obligation bonds and $1.7 billion of refunding GO debt this week. The issue comes in the wake of a favorable result for fiscal 2017 and increased funding for the State’s pension funds. The State, rated Aa3/AA-/AA-, has recently been more restrained in its use of debt, and the pension funding actions have brought the State's funding ratios closer to the 50-state median. Court Street Group Research
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COURT STREET GROUP Research LLC
August 25, 2017
The last time the State came to market was in early March. The 10-year GO with a 5% coupon yielded 2.79% (+36 to AAA BVAL). A block trade of that same bond traded on Tuesday at a 2.02% (+13 to AAA BVAL) yield. The 23 basis point tightening is indicative of broader market credit spread compression as well as investor confidence in the current California economic outlook. As a comparison, we note below a triple-A Vermont deal that priced this week saw its 10-year 5% coupon bond price and subsequently trade at a 1.97% yield (+8 AAA 10-year BVAL). (More on that Vermont deal on page 8.) 10-year California GO Performance Since March
(Source: Bloomberg)
California’s economy continues to perform strongly on an aggregate basis. Its labor force and employment continue to grow, although at 5.4% its unemployment rate is above the national rate. This reflects the State’s demographics, which reflect a higher growth in population and a higher percentage of young people. Personal income per capita is growing faster than is the case for the nation. Total personal income is 13.7% of the U.S., the highest percentage in a decade. The State’s external debt position is much more favorable than was the case in the wake of the financial crisis. California has some $4.7 billion of loans and credit facilities outstanding. While GO and state revenue bond debt stands at a combined $83.9 billion, debt service on the State’s GO and lease debt is a manageable 6.3% of general fund revenues and less than one-half of one percent of the State's $2 trillion of personal income. Outstanding GO debt is a little more than half of the amount of debt authorized to be outstanding. Court Street Group Research
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California’s current credit position also reflects some of its structural characteristics. While economic times are good and financial markets are positive, the state's income tax structure is able to take advantage of its ability to capture income from both high-wage earners as well as investors. This has resulted in some revenue vulnerabilities during economic downturns as the resulting tax base is concentrated among a proportionally small number of large individual taxpayers. When the economy weakens dampening wage income it is often accompanied by disappointing financial market performance. This tends to exaggerate the impact of declines in income on the revenue side of the state budget. Since the expense side is slower to respond and often requires increased social service expenditure during those periods, the result is often budget imbalance and increased short term borrowing requirements. Those periods often find the state in the negative spotlight and the market, in the form of lower prices and wider spreads, responds accordingly. For the long-term investor, their bonds are protected by constitutionally established claims of general state revenues. For those with the opportunity, those times of lower relative prices can often provide a profitable chance to invest in the State's credit. BROADENING THE MARKET FOR MUNICIPAL DEBT Much has been written about the decline in direct retail holdings of municipal bonds, but in CSG’s view, the actual decline is vastly higher than the perceived amount. The reason: from the end of 2010 to the end of 2016, household sector holdings dropped by $309 billion, according to Fed data. However, over that same period we estimate that holdings in separately managed account (SMA) form, which are included in the Household Sector count by the Fed, increased by roughly $250 billion, (Court Street Group estimate). These holdings are not truly “direct retail,”— they are managed on behalf of individuals in non-comingled form, and these types of accounts have virtually none of the attributes that uniquely apply to direct retail. Consequently, direct retail holdings were down by $559 billion during a sixyear period, a remarkable average drop of roughly $93 billion a year. There are a number of factors accounting for this including the perception of lower relative returns for the sector as the result of a favorable rate environment for issuers and lower spreads. However, one of the issues facing the market is the traditional minimum denomination for municipals of $5,000. Recently, the State of Vermont, Aaa/AAA/AA+, completed its annual sale of special “citizen bonds,” available only to Vermont residents, in denominations as low as $1,000. Vermont usually issues GO debt once a year, however, this was their first issuance since 2015, as in 2016 they did not need the money. Typically, a third of their GO issuances go toward citizen bonds. This week, the State issued the general obligation bonds through a negotiated sale via the traditional broker/dealer structure (Morgan Stanley was lead underwriter) and also sold a competitive issue of traditional GOs. The state issued $32.55 million of citizen bonds via negotiation. The $1,000 denomination bonds were priced to yield from 0.78% in 2018 to 1.97% in 2027 (+8 AAA 10-year BVAL) to 2.65% in 2037 (+8 AAA 20year BVAL curve), with a high yield of 3.25% in 2036 (priced at par). As a comparison, the competitive issuance of $65 million saw the 10-year with a 5% coupon at 1.87% (+1 AAA 10-year BVAL), the 2036 with a 3% coupon yielded 3.05%.
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August 25, 2017
The major benefit of the program is to widen the potential market for the bonds by increasing the ability of individuals to buy its debt. Those who wish to invest in its home state now have a greater ability to do so without having to have the substantial resources historically necessary to access the market. Like traditional bonds they trade on the open market. So the bonds are a great opportunity for individuals to gain the benefit of tax-exempt income while supporting their home issuer. PENSION REFORM IN JACKSONVILLE Jacksonville, FL has been an example of a credit weighed down by its unfunded pension liabilities — and there are many more throughout the country. The city, rated Aa3/AA-/AA-, has explored several ways of increasing revenues to address the issue, including pressuring its electric utility (JEA), to ante up more of its operating surplus for general fund expenses. So it was with interest that we looked at the city’s latest offering materials for its recent bond issue. We note that Jacksonville has adopted a significant reform in its pension benefit scheme that is often available to municipalities, but requires some political courage on a city’s part. Jacksonville currently reports a $3.04 billion unfunded liability for its three major defined benefit pension funds. The city has decided that beginning on October 1 of this year that the three plans will be closed to new employees. Those employees instead will be offered a defined contribution pension funding plan. Current employees will remain in the defined benefit plan but their contribution to funding will increase from 8% to 10% of salary. Voters approved a 0.5% tax surcharge, the proceeds of which will be dedicated to pension funding upon expiration of an existing local infrastructure tax which is levied at the same rate.
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The newly approved tax would then be applied to the earlier of the year 2060 or the full funding of pension liabilities. The city is rated Aa3 by Moody’s. The rating reflects the city’s high fixed costs, which are elevated by weak pension funding levels. Because the impact of the pension reforms will occur over time, pension payments are perceived to continue to constrict the city’s financial operations. Nonetheless, the move to implement the reforms has to be viewed favorably. Clearly the desire to maintain strong ratings and relatively favorable borrowing costs are a positive development in the city’s credit outlook. SEC TAKES FIRST POST MCDC ENFORCEMENT AGAINST O’CONNOR AND CO. The Securities and Exchange Commission (SEC) has announced a settlement agreement in its first enforcement action after the close of its Municipalities Continuing Disclosure Cooperation (MCDC) Initiative. This matter involves violations of certain antifraud provisions of the federal securities laws by O'Connor and Co. Securities Inc., a registered broker-dealer and municipal advisor, as well as Tony Wetherbee, its co-founder and one of its primary investment bankers. The action stems from OCSI’s underwriting of a series of bonds for the Beaumont Financing Authority (“BFA”), a municipal entity located in Southern California. Between March 2012 and April 2013, OCSI served as the sole underwriter for five bond offerings by the BFA. As regular readers know, disclosure is a major item of concern for the Perspective. It is heartening that the Commission has stepped forward to take actions to protect investors, which only serves to enhance the marketability and fair valuation of municipal bonds. In connection with each of the offerings, OCSI disseminated official statements that contained false and misleading representations about the City of Beaumont Community Facilities District No. 93-1’s (the “District”) compliance with its prior Continuing Disclosure Agreements (“CDA”). Under those CDAs, the District had covenanted to provide continuing disclosures for the benefit of investors, including annual reports containing financial information and operating data related to bonds being offered. The BFA’s 2012 and 2013 official statements did not disclose several instances in which the District failed to comply with its past CDAs, including by filing annual reports late, filing annual reports that were missing required financial information and operating data, and failing to file annual reports in their entirety as of the time that an official statement was circulated to investors. The SEC concluded that O'Connor had not undertaken sufficient due diligence either through the underwriting process or in its post issuance monitoring role. In addition, it asserted that if OCSI and Wetherbee had reviewed EMMA or the other designated repositories, they would have discovered multiple instances where the District’s annual reports were late, incomplete, or entirely missing as of the time that the BFA issued an official statement representing that the District was in compliance with its CDA obligations. By recommending municipal securities to prospective investors without conducting adequate due diligence (i.e., without conducting a reasonable investigation) on the key representations regarding compliance with prior CDAs contained in the securities’ associated official statements, OCSI and
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Wetherbee violated Sections 17(a)(2) and 17(a)(3) of the Securities Act, MSRB Rule G-17, and Section 15B(c)(1) of the Exchange Act. TAKING A HIT TO MAKE A PLAY AGAINST STADIUM BONDS Taking a hit to make a play is among the most revered of characteristics for a hockey player. Holding on to the puck before making a pass often is the difference between a true scoring play or a sound defensive play. Kiel Center Partners LP, the entity which owns the NHL’s St. Louis Blues apparently does not appreciate that characteristic in the Comptroller of the City of St. Louis, Darlene Green. The partnership has filed suit against Green to force her to sign an agreement approved by the city’s Board of Aldermen that would authorize the issuance of some $64 in debt financing to cover upgrades to the team’s arena. The standoff comes one year after the city and the now Los Angeles Rams could not agree on a financing plan to upgrade the city’s football stadium. The issue is where the money would come from to finance the arena upgrades. The Comptroller stated that “she would work with the Kiel Center Partners and other officials to find an alternate financing strategy—one that would not draw upon the city’s general fund and take money away from essential city services or harm the city’s credit.” She further stated that “at a time when everyone knew the City of St. Louis had to make compromises on its 2018 budget in order to meet a revenue shortfall and citizens are being asked to pay an additional $3 a month for trash pickup and to pay more taxes for police raises, it behooves all to focus on the needs of the citizens.” The Comptroller noted that the city’s credit has been downgraded twice in the last six months, leading to what she believes is a “credit crisis.” At the same time another lawsuit arguing that the earmark represents an unconstitutional "gift" to the Blues' owners is moving forward. That suit, whose plaintiffs include one Alderwoman and the city counselor at the time the Blues’ lease on Scottrade was negotiated, notes that the lease states that the team’s owners were to be responsible for all maintenance on the arena. The stance taken by the City Comptroller is somewhat courageous given the loss of the Rams. At the same time, it highlights the divide between the City and its suburbs. It is not unreasonable for the Court Street Group Research
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Comptroller to question the best use of scarce city funds in support of what is truly a regional asset in the team. While the Blues are active supporters of youth hockey in the greater St. Louis area, the sport’s demographics lend themselves to the suburban sections of the metropolitan area where interest and participation is higher due to the expenses associated with the sport. It should be noted for example that some 30% of employment in the City is accounted for by Illinois residents. The City’s ratings reflect the city’s weak reserve position that will remain challenged in the near-term due to limited revenue raising flexibility as well as the city’s reliance on economically sensitive revenues and below-average resident wealth levels. The rating further considers the city’s large and diverse tax base that serves as a regional economic center with improving economic development activity. Overall, the city’s population continues to decline as part of an ongoing hollowing out of the city in favor of its surrounding suburbs. Like so many cities, St. Louis has seen increased population in its downtown core as younger people are attracted to the convenience of city life coupled with their inability to access the home buying market. As with any urban center which has experienced long-term decline, the road back to robust health is a long one. It should be noted that downtown St. Louis accounts for some 90,000 jobs and population in that same area is now 13,000. MLB TACTICS MOVE TO THE MINOR LEAGUES Meanwhile in Virginia, the owner of the Potomac Nationals announced he will explore moving or selling the minor league team, saying negotiations with Prince William County for a new stadium have hit an impasse. The Prince William County Board of Supervisors voted against a $35 million bond issue to fund a new 4,600-seat ballpark on vacant land at The JBG Cos.’s Stonebridge at Potomac Town Center in Woodbridge. JBG and the county signed a non-binding letter of intent in February to build the stadium on 25 acres at the mixed-use center. The terms of that said the county would issue bonds to cover the entire stadium cost while JBG would provide the land and conduct all site work. The team would pay the county $2.7 million annually to cover debt service and $450,000 annually to JBG for a 30-year ground lease. The Virginia Department of Transportation in June agreed to fund the construction of a $34 million parking garage, which would be owned by the county and serve both commuters and attendees at the stadium. Major League Baseball has issued standards for the stadia in which minor league affiliates play. After a nearly three decade period of stadium building largely financed through municipal bonds, MLB is now trying to repeat the feat at the minor league level. The team has played in its current home since that park was built in 1984. The league has granted the Potomac Nationals a waiver to play there until 2018. By the end of that season, the stadium must be improved to comply with the standards or the Potomac Nationals must identify a new stadium in which to play. DC P3 FOR A SCHOOL RESULTS IN TAXABILITY On January 26, 2017, the District of Columbia received a Proposed Adverse Determination, dated January 19, 2017, from the Internal Revenue Service (IRS) for the $11 million District of Columbia James F. Oyster Court Street Group Research
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Elementary School PILOT Revenue Bonds, Series 1999, which indicated that the interest paid to the beneficial owners of the PILOT Revenue Bonds is not excludable from gross income for purposes of federal income taxation. On March 20, 2017, the District of Columbia filed with the IRS an Appeal of Proposed Adverse Determination. Now the District has decided to redeem the outstanding debt as it appears that the bonds are non-tax exempt private activity bonds. This reflects the use of the site primarily for private real estate purposes and thus it does not meet the qualifications for tax-exemption. The early redemption is likely part of an overall settlement with the IRS that results in a declaration of taxability but does not result in a penalty (other than the opportunity cost of not continuing to receive tax-exempt income going forward) that is in keeping with prior IRS practices. The transaction was the result of a partnership, between LCOR Incorporated, a national real estate firm, the District of Columbia Public Schools and the District of Columbia government. It was established through an agreement under which the developer would finance, design and construct a new Oyster School. ICap acted as financial advisor to LCOR to structure the response to the RFP issued by the District for the project. Jacobs Facilities built the new Oyster School in 1999. In exchange for the commitment to build the new school, the District of Columbia agreed to transfer one half of the Oyster School site to LCOR for private development of a 211-unit residential apartment building, with the “in lieu of ” property taxes from this building dedicated to repay $11 million in tax exempt District of Columbia Revenue Bonds over the 30-year term of the bonds. SANTEE COOPER BOARD DEFERS RATE ACTION On August 11, the South Carolina Public Service Authority board (Santee Cooper) voted to cancel its rate case to provide time to analyze its options to better maintain the utility’s financial position. The cancelled rate case is credit negative, particularly in the absence of permanent cost reductions or securing incremental revenues in the face of rising debt service that is payable from current revenues. Santee Cooper is concerned that customer tolerance for incremental rate increases related to investments in the recently cancelled Summer Nuclear Station is not there at present. If Santee Cooper’s plan to mitigate the need for future rate increases is not realized, its unregulated capability to sufficiently raise rates to meet sound financial metrics would have to be used to maintain its ratings. The canceled rate proposal, would have amounted to about a 4% annual increase in 2018 and 2019. It was initially proposed prior to the utility’s decision to end its participation in the construction of two new nuclear units at Summer. The decision reflects management’s view of the impact of the $2 billion reduction in future capital spending associated with its termination of the nuclear project construction. Santee Cooper intends now to rely upon payments under the Toshiba Corporation parental guarantee which totals $976 million and provides several years of funds at least through 2020 to service new scheduled debt service above the 2016 level (the funds will cover about $150 million of new debt service that will have no capitalized interest). The first payment from Toshiba is scheduled in October 2017.
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Given Toshiba’s severely weakened financial position, the quality and reliability of this funding is vulnerable. Without the Toshiba funds, costs would be 8% higher, which Santee Cooper would have to manage through new revenues, cost reductions or deferrals. Santee Cooper management has announced a cost-reduction plan to lower the utility’s operating expenses and plans to evaluate certain aspects of the utility’s debt structure in an effort to reduce future rate hikes.
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THE WEEKLY MUNICIPAL PERSPECTIVE Executive Summary: Managing Partner, George Friedlander, notes that municipals edged ahead of Treasuries this week on continued light supply, lower refundings and a continued shortage of yield paper making investors gobble up any paper that is out there. He also details the implications for munis with the recent Tax Reform proposals that have been discussed on Capitol Hill. As we note, it seems that Tax Reform remains on track, despite political squabbling between the Administration and Congress. It also seems clear that Republican lawmakers are looking for at least one big win, and that Tax Reform provides the best shot to achieve that. In our Credit Focus, Partner, Joseph Krist, gives a credit overview of next week’s largest deal, a $2.5 billion GO offering out of California; A look at lower-denomination bond deals, specifically a Vermont GO deal priced this week, and why they benefit issuers’ attempts at attracting traditional retail investors; Pension reforms in Jacksonville, FL are a credit positive; St. Louis Comptroller’s fight with the NHL; MLB tries for bonds for the minors; The first post-MCDC SEC fine; A P3 in Washington, D.C. is deemed taxable; and, Santee Cooper defers rate action, a credit negative.
MUNIS MARKET EDGED AHEAD OF TREASURIES ON VERY MODEST SUPPLY: by George Friedlander, Managing Partner
10-Yr AAA Muni to UST (Source: Bloomberg) 2.8
2.6
2.4
2.2
2
With refunding volume continuing to be extremely modest for reasons we discussed last week, the muni market remains firm on extremely modest supply. Issuance over the past two weeks in the aggregate totaled right about $10 billion. Year-to-date issuance continues to fall further behind 2016 levels. At the end of July, issuance was down 13.2%. By August 25, the decline versus last year had increased to 14.5%. With supply so tight, available paper is being gobbled up pretty quickly as it comes to market. And, credit spreads remain tight, given the continuing shortage of yield paper. As we have noted, we believe that new-money issuance, up a couple of percent year-to-date by late August, would probably increase further with more certainty about 1.8
1.6
1.4
1.2
1 5/2/16
6/2/16
7/2/16
8/2/16
9/2/16 10/2/16 11/2/16 12/2/16 1/2/17 MUNI 10YR
Court Street Group Research
2/2/17 3/2/17
4/2/17
5/2/17
6/2/17
7/2/17
8/2/17
UST 10YR
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where any Federal infrastructure bill is headed. As of now, the answer seems to be “nowhere,” and if that is the case, state and local issuers may begin to pick up the pace a bit on their own. Supply next week is about $6.9 billion and we highlight the largest deal, $2.5 billion of California GOs as an example of how credit compression and the general positive investor sentiment over California’s economic outlook have allowed the state to see its 10-year GO spread tighten by 23 basis points since it last came to market. Lipper first reported outflows of $635 million from municipal bond mutual funds but then corrected the figure to actually $750 million of inflows.
AAA 30-Yr Muni to UST (Source: Bloomberg) 3.5 3.4 3.3 3.2 3.1 3.0 2.9 2.8 2.7 2.6 2.5 11/30/16
12/31/16
1/31/17
2/28/17
3/31/17 30yr AAA Muni
4/30/17
5/31/17
6/30/17
7/31/17
30yr UST
As we discuss below, it appears that despite the ongoing political “noise” in Washington, a Tax Reform proposal may be taking shape. And, if that is the case, muni market participants need to keep close track of the provisions that would affect marginal tax rates.
10-Yr AAA Muni to UST (Source: Bloomberg) 2.8
2.6
2.4
THIS WEEK’S NEW DEALS FROM AROUND THE COUNTRY: 2.2
2
1.8
1.6
1.4
1.2
1 5/2/16
6/2/16
7/2/16
8/2/16
9/2/16
10/2/16
11/2/16
12/2/16
MUNI 10YR
1/2/17
2/2/17
3/2/17
4/2/17
5/2/17
6/2/17
7/2/17
UST 10YR
$2.5 billion of various purpose general obligation bonds for the State of California, Aa3/AA-/AA-. Goldman Sachs & Co. LLC is head underwriter. The deal is set to price for retail Monday with pricing for institutions Tuesday. $950 million of AMT priority subordinated airport facilities revenue bonds for the City of Orlando, A1/A+/A+. RBC Capital Markets will head the deal that is set to price on 8/29. $558 million of State of Illinois clean water initiative revolving fund revenue bonds for the Illinois Finance Authority, NR/AAA/AAA. Bank of America Merrill Lynch will lead the deal that will price for retail on Monday and on Tuesday for institutions. $308 million Marshfield Clinic Health System, Inc revenue bonds for the Wisconsin Health & Educational Facilities Authority, NR/A-/A-, Bank of America Merrill Lynch is head underwriter and the deal is set for 8/29. $107 million of Magnolia Power Project A Refunding revenue bonds for the Southern California Public Power Authority, NR/AA-/NR. Goldman Sachs & Co. LLC will head the deal that is set for 8/31.
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Current proposals on Tax Reform suggest a likely dramatic bear flattening of the muni yield curve, if enacted. There appears to be considerable additional information available as to where Tax Reform is headed, based upon information coming out of the tax writing committees and their staff. In particular, an article in Politico dated August 22 laid out a considerable amount of their thinking so far. The article can be found here. We have been able to confirm significant portions of the construct as suggested in the Politico article, and extrapolate from there in terms of potential implications for the municipal bond market and for state and local governments. Our perceptions are summarized here, and then described in greater detail in the following sections. First, it seems that Tax Reform remains on track, despite political squabbling between the Administration and Congress. It seems clear that Republican lawmakers are looking for at least one big win, and that Tax Reform provides the best shot to achieve that. Second, Democrats are likely to fight any such bill on the grounds that it seems likely to largely benefit high-income individuals, but at this point that any such counter-arguments will do little more than limit the scope of the legislation to a greater or lesser degree, rather than foiling passage of Tax Reform outright. Most observers put an target period for enactment in the first quarter of 2018.
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Third, while treatment of munis is at a level of detail that has not yet been discussed, we remain relatively confident that little or nothing will be done to reduce access to the tax-exempt market. However, as we discuss in more detail below, that conclusion if correct, would not mean that state and local governments would end up unscathed. In our view, two main factors would hurt both munis and state and local governments. The first is the strong likelihood that marginal tax rates for potential buyers of munis could be cut rather sharply, requiring an upward adjustment in muni yields to maintain their competitiveness against taxable debt. As we note, the impact of such a shift would be much greater on short to intermediate municipals, but we expect that muni yields all along the curve would be pushed higher: a classic “bear flattener.” In addition, the revenue side of the state and local government ledger would likely come under at least some pressure if deductibility of state and local taxes were to be eliminated, and the mortgage interest deduction were to be capped, as currently seems planned. We also discuss this briefly below. Why we are particularly concerned about tax rates under Tax Reform, in terms of the benefits of the tax exemption. We have discussed the potential effects of changes in tax rates and their effect on the muni market a number of times, but felt that it would be useful to “re-litigate” these concerns in light of what we believe we can ascertain from the information contained in the Politico story and other sources we have contacted in recent days. There are likely changes from current law that we can identify with some confidence, and then others that are more or less uncertain or speculative. We identify each of these below, including our sense as to how likely the are to be included in a Tax Reform bill, if one is enacted, and the potential impact on muni demand. 1 Reduction in the corporate tax rate. We are hearing that a reduction in the corporate tax rate to roughly 23-27%, from the current level of 35%, is almost certain to be included in Tax Reform. There is strong, broad-based support for a drop in the rate to a level which is perceived to be more competitive with those in other developed nations. The negative impact on demand for munis—or more accurately, the shape of the demand curve, would be significantly greater at a 23% tax rate than at a 27% rate, but in either case, muni yields would have to be somewhat higher on a relative basis for munis to compete with corporate bonds on an after-tax basis after a tax rate cut, than they are currently. 2 Reduction in the tax rate for pass-through entities. Pass-throughs include a number of kinds of businesses for which no taxes are paid at the corporate level, but for which net income is passed through to the owners, who then pay taxes at the applicable rate. These entities include partnerships, limited liability corporations and Subchapter S corporations. Under current law, recipients of income from a pass-through pay taxes at their ordinary income tax rate. Proposals to reduce the tax rate on income from pass-throughs is focused largely on “small businesses,” not yet well defined, and the proposed tax rate has varied wildly from one proposal to the next. President Trump had one proposal which would reduce the tax rate to as low as 15%, but that appears to be completely off the table. What we are hearing now is that the tax rate will likely be the same as that on corporations—i.e., 23-27%—or very modestly higher. In any event, this would be a very sharp drop in the maximum tax rate for individuals who receive income from pass-throughs, versus the top 39.6% rate under current law—a Court Street Group Research
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decline of as much as 12.6 to 16.6 percentage points, perhaps slightly less. Clearly, a drop in effective tax rates that large would induce many high-income individuals to seek to receive income as part of a passthrough, and for individuals who can accomplish this, relative yields on munis would have to go higher than they are under current law in order to compete with corporates on an after-tax basis. We view a cut in the maximum tax rate on income from passthroughs to a rate very close to the new corporate tax rate as highly likely. 3 Treatment of taxable bond interest. We continue to hear from a number of sources, including the Politico article, that a whole or partial elimination of the deductibility of corporate bond interest to the issuing corporation is being considered. Every proposal we have seen that eliminates the deductibility of interest for corporations has been accompanied by “capital income” treatment for interest earned by individuals— taxable bond interest, along with dividend income and capital gains, would be taxed at half the maximum income tax rate. This would be radically different from current law, under which dividends and capital gains are taxed at a maximum rate of 20%, plus an additional 3.8% surtax applies on net investment income for taxpayers with adjusted gross income (AGI) over $200,000 (single filers) or $250,000 (married filing jointly)—a maximum 23.8% rate—versus a maximum tax rate on ordinary income, including taxable bond interest, of 39.6%. We are assuming that under tax reform, the 3.8% surtax would likely be eliminated. There is no way to know how corporate interest would be treated if the deductibility were only partially eliminated, but the worst case scenario in terms of competition with munis would be a new tax rate on all taxable bond interest of 17.5%, versus a current maximum rate of 39.6% plus 3.8%, or 43.4%. Note that the whole or partial elimination of deductibility for corporations only applies to corporate debt, but proposals on capital income treatment would apply to all taxable interest, including Treasuries, agencies, mortgage-backed securities, and even the interest paid on the $9.2 trillion of outstanding CDs and savings accounts. This is, we expect, a very big deal. It would essentially gut the value of the tax-exemption to individuals, if the alternative is buying corporates or other vast amounts of other taxable debt taxed at only 17.5%. 4 Elimination of deductibility of state and local taxes, and a portion of mortgage interest. We expect that both of these provisions will be included, and both would put at least modest downward pressure on state and local taxes. Elimination of deductibility of state and local taxes would increase the maximum effective tax rate on state or local income or property taxes by a factor equal to 1/(1 minus the federal tax rate.) In other words, an 8% state tax for an individual who itemizes would currently cost 8% (1-39.6%), or 4.32%, in the maximum Federal bracket. Without deductibility, it would cost the full 8%, putting pressure on a state or local government to lower their tax rate. A partial elimination of the mortgage interest deduction would likely put some downward pressure on the value of homes, thereby reducing property tax collections by some as-yet unspecified amount. 5 Another consideration not yet dealt with: potential elimination of the Alternative Minimum Tax. It would seem likely, although it has not yet been fully discussed, that any full-blown tax reform bill would eliminate the alternative minimum tax for both individuals and corporations. The impact of such a change for municipal bonds would be negligible, except that interest on private activity bonds would no longer be treated less favorably than that on governmental bonds.
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Why the key changes would result in a bear flattening of the municipal yield curve. The bottom line: a combination of lower corporate/pass-through tax rates and treatment of taxable bond interest as capital income would severely reduce the value of the tax-exemption, particularly on short to intermediate muni bonds. It would thus put upward pressure on muni yields, again with the greatest impact felt on short to intermediate paper. Let’s take a look at why this would be the case. Currently, the ratio of double-A muni yields to double-A corporate yields is roughly 52% in 2 years, 54% in 5 years, 65% in 10 years, and 81% in 30 years. The ratio of triple-A muni yields to Treasury yields is roughly 65% in 1-5 years, 87% in 10 years, and 98.3% in 30 years. If the proper comparison were versus Treasuries, then only shorter munis would be particularly vulnerable —munis simply don’t yield enough at proposed pass-through or capital income tax rates at the 65% ratio which prevails in the 1-5 year part of the yield curve. At the 87% ratio on 10-year paper, muni yields would appear to only be modestly too low, and at the 98% ratio on the long end, prevailing muni yields might be sufficient—if that were the proper comparison. Unfortunately, in our view, it isn’t the proper comparison. Munis tend to compete with corporate bonds on an after-tax basis, NOT Treasuries. This, the remarkably low muni/corporate yield ratios that currently exist would have to go considerably higher versus the 52-65% that currently exists in comparison with corporates in 1-10 years, if effective tax rates under capital income rules were to be as has been considered and described above. An 83% ratio the long end would probably also be too low, given factors like noncallability on corporates, but the amount of upward pressure on muni yields would be far less severe than on short and intermediate paper. So, the bottom line is that when compared to corporate bond interest taxed at a very low rate under tax reform (i.e., including capital income treatment), short and intermediate muni yields would have to go sharply higher, and long-term yields would have to go moderately higher, a classic “bear flattener.” Even if rules for corporate bond interest aren’t changed, we expect that if corporations and pass-throughs face a tax rate of 25% or so, short and intermediate muni yields would have to go significantly higher, although the effect on longer paper would likely be fairly modest—albeit still negative. In any event, tax treatment under the proposed changes being considered will have to be tracked very closely as proposals wend their way through the Congress—assuming that they do.
CREDIT FOCUS: by Joseph Krist, Partner CALIFORNIA COMES TO MARKET WITH $2.5B GOs The State of California is planning to issue $800 million of new-money general obligation bonds and $1.7 billion of refunding GO debt this week. The issue comes in the wake of a favorable result for fiscal 2017 and increased funding for the State’s pension funds. The State, rated Aa3/AA-/AA-, has recently been more restrained in its use of debt, and the pension funding actions have brought the State's funding ratios closer to the 50-state median. Court Street Group Research
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The last time the State came to market was in early March. The 10-year GO with a 5% coupon yielded 2.79% (+36 to AAA BVAL). A block trade of that same bond traded on Tuesday at a 2.02% (+13 to AAA BVAL) yield. The 23 basis point tightening is indicative of broader market credit spread compression as well as investor confidence in the current California economic outlook. As a comparison, we note below a triple-A Vermont deal that priced this week saw its 10-year 5% coupon bond price and subsequently trade at a 1.97% yield (+8 AAA 10-year BVAL). (More on that Vermont deal on page 8.) 10-year California GO Performance Since March
(Source: Bloomberg)
California’s economy continues to perform strongly on an aggregate basis. Its labor force and employment continue to grow, although at 5.4% its unemployment rate is above the national rate. This reflects the State’s demographics, which reflect a higher growth in population and a higher percentage of young people. Personal income per capita is growing faster than is the case for the nation. Total personal income is 13.7% of the U.S., the highest percentage in a decade. The State’s external debt position is much more favorable than was the case in the wake of the financial crisis. California has some $4.7 billion of loans and credit facilities outstanding. While GO and state revenue bond debt stands at a combined $83.9 billion, debt service on the State’s GO and lease debt is a manageable 6.3% of general fund revenues and less than one-half of one percent of the State's $2 trillion of personal income. Outstanding GO debt is a little more than half of the amount of debt authorized to be outstanding. Court Street Group Research
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California’s current credit position also reflects some of its structural characteristics. While economic times are good and financial markets are positive, the state's income tax structure is able to take advantage of its ability to capture income from both high-wage earners as well as investors. This has resulted in some revenue vulnerabilities during economic downturns as the resulting tax base is concentrated among a proportionally small number of large individual taxpayers. When the economy weakens dampening wage income it is often accompanied by disappointing financial market performance. This tends to exaggerate the impact of declines in income on the revenue side of the state budget. Since the expense side is slower to respond and often requires increased social service expenditure during those periods, the result is often budget imbalance and increased short term borrowing requirements. Those periods often find the state in the negative spotlight and the market, in the form of lower prices and wider spreads, responds accordingly. For the long-term investor, their bonds are protected by constitutionally established claims of general state revenues. For those with the opportunity, those times of lower relative prices can often provide a profitable chance to invest in the State's credit. BROADENING THE MARKET FOR MUNICIPAL DEBT Much has been written about the decline in direct retail holdings of municipal bonds, but in CSG’s view, the actual decline is vastly higher than the perceived amount. The reason: from the end of 2010 to the end of 2016, household sector holdings dropped by $309 billion, according to Fed data. However, over that same period we estimate that holdings in separately managed account (SMA) form, which are included in the Household Sector count by the Fed, increased by roughly $250 billion, (Court Street Group estimate). These holdings are not truly “direct retail,”— they are managed on behalf of individuals in non-comingled form, and these types of accounts have virtually none of the attributes that uniquely apply to direct retail. Consequently, direct retail holdings were down by $559 billion during a sixyear period, a remarkable average drop of roughly $93 billion a year. There are a number of factors accounting for this including the perception of lower relative returns for the sector as the result of a favorable rate environment for issuers and lower spreads. However, one of the issues facing the market is the traditional minimum denomination for municipals of $5,000. Recently, the State of Vermont, Aaa/AAA/AA+, completed its annual sale of special “citizen bonds,” available only to Vermont residents, in denominations as low as $1,000. Vermont usually issues GO debt once a year, however, this was their first issuance since 2015, as in 2016 they did not need the money. Typically, a third of their GO issuances go toward citizen bonds. This week, the State issued the general obligation bonds through a negotiated sale via the traditional broker/dealer structure (Morgan Stanley was lead underwriter) and also sold a competitive issue of traditional GOs. The state issued $32.55 million of citizen bonds via negotiation. The $1,000 denomination bonds were priced to yield from 0.78% in 2018 to 1.97% in 2027 (+8 AAA 10-year BVAL) to 2.65% in 2037 (+8 AAA 20year BVAL curve), with a high yield of 3.25% in 2036 (priced at par). As a comparison, the competitive issuance of $65 million saw the 10-year with a 5% coupon at 1.87% (+1 AAA 10-year BVAL), the 2036 with a 3% coupon yielded 3.05%.
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The major benefit of the program is to widen the potential market for the bonds by increasing the ability of individuals to buy its debt. Those who wish to invest in its home state now have a greater ability to do so without having to have the substantial resources historically necessary to access the market. Like traditional bonds they trade on the open market. So the bonds are a great opportunity for individuals to gain the benefit of tax-exempt income while supporting their home issuer. PENSION REFORM IN JACKSONVILLE Jacksonville, FL has been an example of a credit weighed down by its unfunded pension liabilities — and there are many more throughout the country. The city, rated Aa3/AA-/AA-, has explored several ways of increasing revenues to address the issue, including pressuring its electric utility (JEA), to ante up more of its operating surplus for general fund expenses. So it was with interest that we looked at the city’s latest offering materials for its recent bond issue. We note that Jacksonville has adopted a significant reform in its pension benefit scheme that is often available to municipalities, but requires some political courage on a city’s part. Jacksonville currently reports a $3.04 billion unfunded liability for its three major defined benefit pension funds. The city has decided that beginning on October 1 of this year that the three plans will be closed to new employees. Those employees instead will be offered a defined contribution pension funding plan. Current employees will remain in the defined benefit plan but their contribution to funding will increase from 8% to 10% of salary. Voters approved a 0.5% tax surcharge, the proceeds of which will be dedicated to pension funding upon expiration of an existing local infrastructure tax which is levied at the same rate.
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The newly approved tax would then be applied to the earlier of the year 2060 or the full funding of pension liabilities. The city is rated Aa3 by Moody’s. The rating reflects the city’s high fixed costs, which are elevated by weak pension funding levels. Because the impact of the pension reforms will occur over time, pension payments are perceived to continue to constrict the city’s financial operations. Nonetheless, the move to implement the reforms has to be viewed favorably. Clearly the desire to maintain strong ratings and relatively favorable borrowing costs are a positive development in the city’s credit outlook. SEC TAKES FIRST POST MCDC ENFORCEMENT AGAINST O’CONNOR AND CO. The Securities and Exchange Commission (SEC) has announced a settlement agreement in its first enforcement action after the close of its Municipalities Continuing Disclosure Cooperation (MCDC) Initiative. This matter involves violations of certain antifraud provisions of the federal securities laws by O'Connor and Co. Securities Inc., a registered broker-dealer and municipal advisor, as well as Tony Wetherbee, its co-founder and one of its primary investment bankers. The action stems from OCSI’s underwriting of a series of bonds for the Beaumont Financing Authority (“BFA”), a municipal entity located in Southern California. Between March 2012 and April 2013, OCSI served as the sole underwriter for five bond offerings by the BFA. As regular readers know, disclosure is a major item of concern for the Perspective. It is heartening that the Commission has stepped forward to take actions to protect investors, which only serves to enhance the marketability and fair valuation of municipal bonds. In connection with each of the offerings, OCSI disseminated official statements that contained false and misleading representations about the City of Beaumont Community Facilities District No. 93-1’s (the “District”) compliance with its prior Continuing Disclosure Agreements (“CDA”). Under those CDAs, the District had covenanted to provide continuing disclosures for the benefit of investors, including annual reports containing financial information and operating data related to bonds being offered. The BFA’s 2012 and 2013 official statements did not disclose several instances in which the District failed to comply with its past CDAs, including by filing annual reports late, filing annual reports that were missing required financial information and operating data, and failing to file annual reports in their entirety as of the time that an official statement was circulated to investors. The SEC concluded that O'Connor had not undertaken sufficient due diligence either through the underwriting process or in its post issuance monitoring role. In addition, it asserted that if OCSI and Wetherbee had reviewed EMMA or the other designated repositories, they would have discovered multiple instances where the District’s annual reports were late, incomplete, or entirely missing as of the time that the BFA issued an official statement representing that the District was in compliance with its CDA obligations. By recommending municipal securities to prospective investors without conducting adequate due diligence (i.e., without conducting a reasonable investigation) on the key representations regarding compliance with prior CDAs contained in the securities’ associated official statements, OCSI and
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Wetherbee violated Sections 17(a)(2) and 17(a)(3) of the Securities Act, MSRB Rule G-17, and Section 15B(c)(1) of the Exchange Act. TAKING A HIT TO MAKE A PLAY AGAINST STADIUM BONDS Taking a hit to make a play is among the most revered of characteristics for a hockey player. Holding on to the puck before making a pass often is the difference between a true scoring play or a sound defensive play. Kiel Center Partners LP, the entity which owns the NHL’s St. Louis Blues apparently does not appreciate that characteristic in the Comptroller of the City of St. Louis, Darlene Green. The partnership has filed suit against Green to force her to sign an agreement approved by the city’s Board of Aldermen that would authorize the issuance of some $64 in debt financing to cover upgrades to the team’s arena. The standoff comes one year after the city and the now Los Angeles Rams could not agree on a financing plan to upgrade the city’s football stadium. The issue is where the money would come from to finance the arena upgrades. The Comptroller stated that “she would work with the Kiel Center Partners and other officials to find an alternate financing strategy—one that would not draw upon the city’s general fund and take money away from essential city services or harm the city’s credit.” She further stated that “at a time when everyone knew the City of St. Louis had to make compromises on its 2018 budget in order to meet a revenue shortfall and citizens are being asked to pay an additional $3 a month for trash pickup and to pay more taxes for police raises, it behooves all to focus on the needs of the citizens.” The Comptroller noted that the city’s credit has been downgraded twice in the last six months, leading to what she believes is a “credit crisis.” At the same time another lawsuit arguing that the earmark represents an unconstitutional "gift" to the Blues' owners is moving forward. That suit, whose plaintiffs include one Alderwoman and the city counselor at the time the Blues’ lease on Scottrade was negotiated, notes that the lease states that the team’s owners were to be responsible for all maintenance on the arena. The stance taken by the City Comptroller is somewhat courageous given the loss of the Rams. At the same time, it highlights the divide between the City and its suburbs. It is not unreasonable for the Court Street Group Research
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COURT STREET GROUP Research LLC
August 25, 2017
Comptroller to question the best use of scarce city funds in support of what is truly a regional asset in the team. While the Blues are active supporters of youth hockey in the greater St. Louis area, the sport’s demographics lend themselves to the suburban sections of the metropolitan area where interest and participation is higher due to the expenses associated with the sport. It should be noted for example that some 30% of employment in the City is accounted for by Illinois residents. The City’s ratings reflect the city’s weak reserve position that will remain challenged in the near-term due to limited revenue raising flexibility as well as the city’s reliance on economically sensitive revenues and below-average resident wealth levels. The rating further considers the city’s large and diverse tax base that serves as a regional economic center with improving economic development activity. Overall, the city’s population continues to decline as part of an ongoing hollowing out of the city in favor of its surrounding suburbs. Like so many cities, St. Louis has seen increased population in its downtown core as younger people are attracted to the convenience of city life coupled with their inability to access the home buying market. As with any urban center which has experienced long-term decline, the road back to robust health is a long one. It should be noted that downtown St. Louis accounts for some 90,000 jobs and population in that same area is now 13,000. MLB TACTICS MOVE TO THE MINOR LEAGUES Meanwhile in Virginia, the owner of the Potomac Nationals announced he will explore moving or selling the minor league team, saying negotiations with Prince William County for a new stadium have hit an impasse. The Prince William County Board of Supervisors voted against a $35 million bond issue to fund a new 4,600-seat ballpark on vacant land at The JBG Cos.’s Stonebridge at Potomac Town Center in Woodbridge. JBG and the county signed a non-binding letter of intent in February to build the stadium on 25 acres at the mixed-use center. The terms of that said the county would issue bonds to cover the entire stadium cost while JBG would provide the land and conduct all site work. The team would pay the county $2.7 million annually to cover debt service and $450,000 annually to JBG for a 30-year ground lease. The Virginia Department of Transportation in June agreed to fund the construction of a $34 million parking garage, which would be owned by the county and serve both commuters and attendees at the stadium. Major League Baseball has issued standards for the stadia in which minor league affiliates play. After a nearly three decade period of stadium building largely financed through municipal bonds, MLB is now trying to repeat the feat at the minor league level. The team has played in its current home since that park was built in 1984. The league has granted the Potomac Nationals a waiver to play there until 2018. By the end of that season, the stadium must be improved to comply with the standards or the Potomac Nationals must identify a new stadium in which to play. DC P3 FOR A SCHOOL RESULTS IN TAXABILITY On January 26, 2017, the District of Columbia received a Proposed Adverse Determination, dated January 19, 2017, from the Internal Revenue Service (IRS) for the $11 million District of Columbia James F. Oyster Court Street Group Research
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COURT STREET GROUP Research LLC
August 25, 2017
Elementary School PILOT Revenue Bonds, Series 1999, which indicated that the interest paid to the beneficial owners of the PILOT Revenue Bonds is not excludable from gross income for purposes of federal income taxation. On March 20, 2017, the District of Columbia filed with the IRS an Appeal of Proposed Adverse Determination. Now the District has decided to redeem the outstanding debt as it appears that the bonds are non-tax exempt private activity bonds. This reflects the use of the site primarily for private real estate purposes and thus it does not meet the qualifications for tax-exemption. The early redemption is likely part of an overall settlement with the IRS that results in a declaration of taxability but does not result in a penalty (other than the opportunity cost of not continuing to receive tax-exempt income going forward) that is in keeping with prior IRS practices. The transaction was the result of a partnership, between LCOR Incorporated, a national real estate firm, the District of Columbia Public Schools and the District of Columbia government. It was established through an agreement under which the developer would finance, design and construct a new Oyster School. ICap acted as financial advisor to LCOR to structure the response to the RFP issued by the District for the project. Jacobs Facilities built the new Oyster School in 1999. In exchange for the commitment to build the new school, the District of Columbia agreed to transfer one half of the Oyster School site to LCOR for private development of a 211-unit residential apartment building, with the “in lieu of ” property taxes from this building dedicated to repay $11 million in tax exempt District of Columbia Revenue Bonds over the 30-year term of the bonds. SANTEE COOPER BOARD DEFERS RATE ACTION On August 11, the South Carolina Public Service Authority board (Santee Cooper) voted to cancel its rate case to provide time to analyze its options to better maintain the utility’s financial position. The cancelled rate case is credit negative, particularly in the absence of permanent cost reductions or securing incremental revenues in the face of rising debt service that is payable from current revenues. Santee Cooper is concerned that customer tolerance for incremental rate increases related to investments in the recently cancelled Summer Nuclear Station is not there at present. If Santee Cooper’s plan to mitigate the need for future rate increases is not realized, its unregulated capability to sufficiently raise rates to meet sound financial metrics would have to be used to maintain its ratings. The canceled rate proposal, would have amounted to about a 4% annual increase in 2018 and 2019. It was initially proposed prior to the utility’s decision to end its participation in the construction of two new nuclear units at Summer. The decision reflects management’s view of the impact of the $2 billion reduction in future capital spending associated with its termination of the nuclear project construction. Santee Cooper intends now to rely upon payments under the Toshiba Corporation parental guarantee which totals $976 million and provides several years of funds at least through 2020 to service new scheduled debt service above the 2016 level (the funds will cover about $150 million of new debt service that will have no capitalized interest). The first payment from Toshiba is scheduled in October 2017.
Court Street Group Research
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COURT STREET GROUP Research LLC
August 25, 2017
Given Toshiba’s severely weakened financial position, the quality and reliability of this funding is vulnerable. Without the Toshiba funds, costs would be 8% higher, which Santee Cooper would have to manage through new revenues, cost reductions or deferrals. Santee Cooper management has announced a cost-reduction plan to lower the utility’s operating expenses and plans to evaluate certain aspects of the utility’s debt structure in an effort to reduce future rate hikes.
Court Street Group Research
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