Puerto Rico casts shadow on muni market
By Vivianne Rodriguesin New York
In his classic tune about mismatched love, Puerto Rican salsa pioneer Ismael Rivera declared "You know well, I'm not for you." Now decades later, as the Caribbean island is once again rattling the US$4tn US municipal debt market, investors are wondering if Puerto Rican paper isn't really for them either.
A move by Puerto Rico to allow some public companies to restructure their debt last month sparked a credit downgrade, and brought a rally in debt sold by the US commonwealth to a halt.
Puerto Rico securities are widely held among pension and mutual funds, which have benefited from the bonds' exemptions from municipal, state and federal taxes. Investors fear that should the change in Puerto Rican legislation ultimately lead to a wave of restructurings on the island it may weigh on the outlook for the broad muni market in 2014.
"Because Puerto Rico bonds are held by so many funds, everything that impacts their outlook also has the potential to impact broad markets," says Chris Ryon, co-portfolio manager of Thornburg Municipal Bond Funds.
The latest worries over Puerto Rico's ability to meet its debt obligations, which exceed the US$70bn mark, came as muni bonds were on the mend in recent months after an abysmal performance last year - their worst in almost two decades.
But the bonds have experienced a stunning reversal in 2014 as fears of imminent default in Puerto Rico had eased and generous tax breaks boosted the allure of the securities.
The rally in muni debt has catapulted the group to the top performing position among US fixed income assets classes, with total returns of 5.6 per cent year-to-date, according to Barclays' indices. That compares with returns of 4.8 per cent for investment grade corporate debt, and 2.1 per cent for US Treasuries.
"Munis have been traditionally a very good asset class and the rebound this year has been very strong," says Mr Ryon. "But trouble with one or two large issuers, such as Puerto Rico, can change people's perception about the broad market."
The question for investors now is whether the muni rally from early this year is sustainable, and if tax incentives are strong enough to entice investors in the face of lingering risks.
On one side, is the possibility of a debt restructuring worth close to US$20bn in some of Puerto Rico's government utilities.
A bill signed by Alejandro Garcia Padilla, Puerto Rico's governor, late in June enables the utilities to negotiate repayments to bondholders for a period of several months. While the governor has defended the bill, saying it allowed public companies to address their financial difficulties, analysts saw the bill as a departure from the island's commitment to bondholders.
Moody's cut its Puerto Rico credit deeper into "junk" territory and warned that the legislation provided "a clear path to default" for public companies. Standard & Poor's also signalled it may cut Puerto Rico's rating within 60 to 90 days.
Puerto Rico bonds sold off, pushing yields on general obligation debt 19 basis points higher to 8.27 per cent on Monday, according to Thomson Reuters data.
"The situation with the legislation has become unpredictable, and that's precisely one of the reasons why we have avoided Puerto Rico debt for some time," says Stephen Winterstein, chief strategist for municipal fixed income at Wilmington Trust Investment Advisors.
In spite of Puerto Rico debt woes, however, investors should not rush to sell muni bonds as they did last year, Mr Winterstein says.
As an incentive to invest in public projects and to keep borrowing costs low, interest income from munis is exempt from federal taxes. Some are also exempt from state and local taxes too.
The tax advantage is clear. An investor in a 35 per cent tax bracket would have to find a taxable security, such as a corporate bond, that yields more than 8 per cent to earn the same amount of income, according to analysts' estimates.
"The majority of muni bonds is high-quality and tax exempt. It's a very reliable asset class," says Mr Winterstein.
In addition, another driver of muni performance will be interest rates, analysts say. Muni prices, like those of other bonds, fall as rates rise. But in an environment of rising rates, munis tend to outperform US Treasuries.
The extent to which they can do that and potentially eke out some gains this year may depend on how dramatically rates rise and whether fears of credit risks in Puerto Rico do materialise, says Tom Weyl, a municipal debt strategist Barclays.
"People are worried about Puerto Rico, but ultimately is more about overall rates in the Treasury market," he says. "If we see an orderly increase in Treasury rates, chances are munis will still outperform the broad market."
(c) 2014 The Financial Times Limited