No discussion of the municipal markets would be complete without mentioning Puerto Rico. Other than the nightmare which is Detroit (where bondholders could be crammed down in favor of public employee pensions), Puerto Rico has been the dominant story in the municipal debt world.
Last Friday, both Moody’s and S&P downgraded Puerto Rico general obligation debt to junk status (Ba2/BB+). This was not surprising to us. Puerto Rico G.O. debt had been trading at distressed debt levels since last September. Although we believe that trading levels (which are similar to CCC-rated credits) are overdone to the downside, Puerto Rico debt is not without risk.
Let us first make two things very clear:
- We do not own Puerto Rico debt in any fixed income portfolio which we manage.
- Puerto Rico G.O. bonds are (in our opinion) appropriate only for aggressive or speculative investors.
Although the commonwealth has made progress in repairing its damaged economy, challenges remain. This is mainly in the area of tax revenue and expenditures. There are concerns that the U.S. tax credit, which corporations receive when paying excise taxes collected by Puerto Rico, could be eliminated by the IRS. The IRS is currently reviewing the situation, but has chosen to let the credit stand while it reviews tax policy. This tax credit incentivizes some corporations to conduct business activities in Puerto Rico. If the IRS decides that the credit will no longer be allowed, corporations could be disincentivized from conducting business activities in the Commonwealth. This would be a blow to Puerto Rico’s tax revenue.
Obviously, this could do harm to Puerto Rico’s efforts to repair its balance sheet and makes little sense in the grand scheme, but we do not put it beyond the realm of possibility that the IRS (or any agency or branch of government) would act in such a manner which precipitates a Puerto Rico default. However, the good news is that a decision on the Puerto Rico excise tax has been put off. This could be seen as evidence that the government is not willing to make life even more difficult for Puerto Rico.
Although we believe that Puerto Rico G.O. debt will most likely end up as “money good,” we prefer sales tax bonds (Cofinas) which remain investment grade and which do not have (to the best of our knowledge) so-called claw-back provisions which allow the government of Puerto Rico to essentially seize revenues to repay G.O. debt. Most other revenue bonds have claw-back provisions, thus making them less secure than what one might expect from a revenue bond.
The following is our preference for Puerto Rico debt:
- Sales Tax Bonds (Cofinas): Revenues appear to be free of claw-back provisions.
- Puerto Rico G.O.s: Government can constitutionally claw-back revenues (other than from sales tax) to pay G.O. debt.
- All Other Revenue Bonds: As of now, the Puerto Rico constitution permits the government to seize revenues to pay G.O. debt.
Yields and credit ratings reflect the various levels of risk. Readers; if you find a Puerto Rico bond which appears to be “too cheap” chances are that the bond you have found carries more risk than you might wish to incur. That being said, if Puerto Rico was to let one class of bonds default, it could lead to a “contagion” in which the market questions Puerto Rico’s commitment to service its debt. We do not believe that Puerto Rico will take the “easy way” out and allow a class of bonds to default unless it had absolutely no other choice.
There could be some price weakness among Puerto Rico debt as some municipal bond indices will have to be adjusted due to credit downgrades to junk. However, many portfolio managers who are not engaging in an index strategy will probably be able to hold their Puerto Rico debt, if they see fit to do so.
By this time Puerto Rico’s story should be well known. What is not known is how further deterioration of Puerto Rico (if not an actual default) would affect the municipal bond market as a whole. It is our opinion that most of the negative effects of a Puerto Rico default are built into both the prices of Puerto Rico G.O.s and in the broader fixed income market. However, if Puerto Rico’s situation continues to deteriorate, there could be more selling of “good” municipal bond assets as portfolio managers often must sell what they can, rather than what they wish. We would advise investors who are holding actual high-quality municipal bonds in their accounts against selling bonds into Puerto Rico-derived weakness. In fact, we would use any resulting weakness to add high quality bonds to portfolios (where appropriate).
By Thomas Byrne – Director of Fixed Income – Investment Consultant
Thomas Byrne brings 26 years of financial services experience to Wealth Strategies & Management LLC. He spent the last 23 years as Director of Taxable Fixed Income for Citigroup, Inc. and predecessor firms in New York, NY. During the course of his long fixed income career, Mr. Byrne was responsible for trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt and convertible bonds. Mr. Byrne was also responsible for marketing, sales, strategy and market commentary within the taxable fixed income markets.
- November 2012 – Present, Wealth Strategies & Management LLC, Stroudsburg PA
- December 2011 – November 2012 – Bond Squad, Kunkletown, PA
- April 1988 – December 2011, Citigroup and predecessor firms, New York, NY
- June 1986 – March 1988 – E.F. Hutton, New York, NYThomas ByrneDirector of Fixed IncomeWealth Strategies & Management LLC570-424-1555 Office570-234-6350 CellE-mail: Thomas.email@example.comTwitter: @Bond_Squad
High yield/junk bonds (grade BB or below) are not investment grade securities, and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
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