Chicago and Puerto Rico Show How Not to Do It

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The news from Chicago today was amazing. The city issued taxable bonds. Think about that. In principle they could issue tax-exempt bonds and pay a lower interest rate. Why didn’t they do that? And how is this related to Puerto Rico? The answers are pretty straightforward, but in my usual fashion, I’ll turn this into a learning exercise.

Chicago, Chicago, A Wonderful Town

Today Chicago issued $730 million in taxable bonds and $344 million in tax-exempt bonds. According to BondBuyer.com.

The sale offers $344 million of tax-exempt bonds and $730 million of taxable bonds, with much of the sale moving short-term debt into a longer, fixed-rate term with capitalized interest for two and a half years. William Blair & Co. and Siebert Brandford Shank & Co. are co-seniors and another eight firms rounding out the syndicate as co-managers.

With such a big chunk of taxable securities, the city is broadening its universe of buyers who may be willing to overlook the city’s fiscal struggles and invest in a deal designed to clear the city’s balance sheet of operating costs at the expense of its long-term debt load.

The limited amount of tax-exempt paper should help, given the market’s recent absorption of more than $650 of tax-exempt city GO [general obligation] paper.

Why issue taxable securities? BondBuyer gives a plausible excuse (see above). But later in the article they note→

Note the gotcha in there. The first 2-1/2 years of interest (presumably coupon payments) are capitalized and become part of the maturation value. I cannot count the number of municipal agencies (including school districts) that have gotten themselves into serious trouble with stunts like this.

And the sale will go on. Here’s what CNBC says:

Underwriters priced nearly $743 million of taxable Chicago general obligation bonds with yields topping out at 7.98 percent for debt maturing in 2042. Bonds due in 2023 were priced at par with a 6.361 percent coupon, representing a big spread of 400 basis points over comparable U.S. Treasuries.

Chicago is paying nearly 8 percent for 27 year bonds. Even the eight-year bonds were over 6 percent. By comparison, the Wall Street Journal reports that junk bond yields range from 6 to 11.7 percent — and the latter is for CCC rated bonds. Frankly, I didn’t even know such a rating existed.

Junk Bond Yields

Junk Bond Yields (click for larger image)

In other words, Chicago is paying junk bond yields. But how would you like to get a 12.75 percent yield on tax-free bonds?

Puerto Rico

Some Puerto Rican bonds were selling for about 68 cents on the dollar Tuesday. An 8 percent 2035 bond, issued three years ago, was yielding 12.77 percent Tuesday, up from 10.75 percent Friday.

Puerto Rico is the place to park your cash! After all, according to CNBC→

And those are tax-exempt bonds. With a marginal tax rate of, say, 33%, the taxable-equivalent yield is a whopping 19.13%.  And my calculations say the price is more like $0.6612 per dollar of maturation value.

WAIT! STOP! DON’T DO THAT!

Puerto Rico is broke. Yahoo finance says,

Governor Alejandro Padilla has stated that Puerto Rico is bankrupt and it is mathematically impossible to repay the creditors. Imposing sales tax in 2006, retrenchment of public employees in 2009, pension reform in 2013, and the latest gas tax and the Sales and Use Tax (IVU) were some of the measures Puerto Rico had been trying to effectively use. Unfortunately, it failed to restrict the country from amassing about $73 billion of debt, which translates into over $20,000 per person in Puerto Rico. This ironically is more than the median income of $19,520 per year.

In other words, Puerto Rico’s per-capita debt exceeds per-capita income. Putting this another way, even if the government seized 100 percent of income they still would not be able to pay off the debt. And, of course, at a 100 percent tax rate nobody would work and income would be near zero. (OK, people would work but reported income would be zero. The underground economy would be the entire economy.)

Conclusion

Don’t buy Chicago bonds. Unless your net worth is at least $1 billion, don’t buy Puerto Rico bonds. Scrutinize the holdings of any bond funds in which you own an interest. Most analyses have shown that the exposure to Puerto Rico bonds is pretty low. But Chicago bonds are another story. Puerto Rico has beach-front property in a tropical climate and could be a vacation paradise. Chicago? Not so much. Those arguing that Chicago has a thriving industrial base and an economy that’s in great shape are ignoring the realities of both Chicago and Illinois budgeting. Chicago is in bad shape. The state of Illinois’ condition is worse. If you’re considering buying any muni bonds issued in Illinois, I have one word of advice: don’t. Run fast, run far.

Ordinarily I’d include a link to the Excel workbook.  But these calculations are so trivial I’m not going to take the time.  If you’d like it, e-mail me.