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Fixed-Income Insights

Here's a look at some of the factors that led to the commonwealth's muni-market challenges—and the implications for portfolio managers.

 

In Brief

  • Investors may find it worthwhile to understand the history behind the significant changes in Puerto Rico’s standing in the municipal bond market; it informs the current situation.
  • One important contributor to Puerto Rico’s current challenges was the role of municipal bond insurers in the municipal market. Subsequent ratings changes affected the commonwealth’s cost to access the market, but it was still able to issue a high volume of bonds.
  • Rating changes also led to another consequential development: a shift of Puerto Rico bonds from investment-grade municipal bond indexes to high-yield indexes. 
  • In understanding the current situation, it’s important to note that Puerto Rico features an array of muni issuers. This suggests a variety of possible investment outcomes in any prospective resolution of the island’s fiscal and debt issues.
  • Investment managers also must weigh the proper amount of Puerto Rico debt to include in representative municipal bond portfolios.
  • The key takeaway—Puerto Rico has had an important presence in the municipal bond market for a long time. In response to the recent volatility, portfolio managers need to comprehensively analyze the composition of the market to determine how Puerto Rico bonds should be positioned in their funds.

 

Puerto Rico's long-standing challenges in the municipal bond market may have entered a new phase. On July 30, Bloomberg reported that the commonwealth’s Public Finance Corp. likely will fail to make $58 million in bond payments due Saturday, Aug. 1. (The PFC actually has until the end of business on Monday, Aug. 3, to make the payment.)  Bloomberg reported that Puerto Rico was preparing to release a debt-restructuring plan by Sept. 1.

We’ll have more to say on the situation as developments warrant. But given the current fiscal and market status of the commonwealth, we thought it would be worthwhile to review its history in the muni sector, and where things stand today.

For a long time, Puerto Rico bonds have been a core position in municipal bond funds. They always traded at lower yields than their credit quality warranted because they always drew a good amount of demand owing to their triple tax-exempt status, under which interest paid on the bonds has been exempt from federal, state, and local taxes across all U.S. states. This meant that a state-specific muni bond fund targeting a state with a limited supply of muni securities would typically own a good amount of Puerto Rico bonds because they could provide liquidity, diversification, and supply during times when the target state did not have a lot of bonds issued.

Also, in the years before the financial crisis of 2008–09, when bond insurers had ‘AAA’ ratings, many Puerto Rico bonds came to market with bond insurance, so they were considered suitable for a fund’s allocation to high-quality muni securities. During this time, the yield spread between uninsured and insured Puerto Rico bonds was quite narrow because it was most often based upon the cost for the bond insurance, which was not that high. So, the markets were very liquid, and many market participants were involved.

The Role of Ratings
Then the credit crisis occurred, and the bond insurers lost their ‘AAA’ ratings. Puerto Rico bonds had to come to market based on their own credit quality rather than the rating of the bond insurers. Until recent years, the bonds’ values held up sufficiently. Given strong flows into mutual funds after the credit crisis and the triple tax exemption, demand remained strong and Puerto Rico was able to issue a lot of debt at reasonably attractive yields. This actually is one of the reasons that the commonwealth has financial issues today; since it was easy for Puerto Rico to sell bonds at attractive yields, it had a large volume of issuance. The market became a little less liquid because the bond insurers were no longer defining the credit spreads with their premiums, but the bonds were still not that difficult to trade.

Over the past couple of years, the market for Puerto Rico bonds has clearly changed. When the island’s Power Authority brought a deal to the market in August 2013, for example, there was plenty of demand and the bonds still had investment-grade ratings. Investors were becoming more concerned about the issuer’s fundamentals, however, and the deal was priced at yields that clearly reflected a market consensus that the bonds were no longer investment grade, despite opinions to the contrary from major credit rating agencies. Still, the deal was well-received. By the time of the next large deal, a Puerto Rico general obligation bond in March 2014, the ratings had moved to below investment grade, and many municipal bond mutual funds were no longer willing to buy Puerto Rico securities. To sell this deal, hedge funds and other entities that typically did not participate in the muni market were the primary buyers.

The proportion of outstanding Puerto Rico bonds held in municipal bond mutual funds has been steadily falling since that time, while the percentage owned by hedge funds has been growing. Now, if Puerto Rico wants to find financing in the bond market, it is dependent primarily on hedge funds and, to a lesser extent, on some of the large traditional buyers who may still wish to invest in the commonwealth’s debt.

Watching the Weightings
Since this is a lot of detail, it is important to quantify the market impact. Table 1 shows the evolution of the Puerto Rico weighting in Barclays High Yield Municipal Bond Index compared with the weighting in the investment-grade Barclays Municipal Bond Index. During 2007, Puerto Rico bonds represented 3.23% of the high-yield index; but now, with the island’s bonds firmly in speculative-grade territory, that figure is 23.59%. The weighting has actually been higher during the past year, but has fallen along with the market value of Puerto Rico bonds. In comparison, the Municipal Bond Index, representing the investment-grade portion of the market, had 3.67% in Puerto Rico bonds in 2007 but only 1.24% today. It has dropped over the past two years as Puerto Rico has been downgraded and mostly removed from the index other than bonds insured by stronger bond insurers. Puerto Rico bonds now have a much larger impact on their index since the bonds have moved from the investment grade index to the much smaller high-yield index.

 

Table 1. How Have Index Weightings of Puerto Rico Muni Bonds Changed Over Time?
Index weightings (based on market value) of Puerto Rico municipal debt in fiscal 2007–15 (ended June 30)

Source: Barclays. Barclays HY Muni Bond Index=Barclays High Yield Municipal Bond Index. Barclays Muni Bond Index=Barclays Municipal Bond Index.
The historical data are for illustrative purposes only, do not represent the performance of any Lord Abbett mutual fund or any particular investment, and are not intended to predict or depict future results. Investors may experience different results. Performance during other time periods may differ. Due to market volatility, the market may not perform in a similar manner in the future. Dividends are not guaranteed and may be increased, decreased, or suspended altogether at the discretion of the issuing company. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
Past performance is no guarantee of future results.

 

In analyzing the overall prospects for the island’s muni bonds, it’s worth noting a statement made by a representative of an advisory firm hired by Puerto Rico at a meeting with investors on July 13. He mentioned that the island’s issuers would be looked at individually in determining how Puerto Rico would respond to their financial problems. This suggests that different issuers will have different outcomes, so it is important to understand the current composition of these entities in the Barclays High Yield Muni Index. There are a range of Puerto Rico issuers, reflecting a variety of revenue sources from which bonds are repaid; thus, they do not all share the same credit characteristics. The largest and best-known category is the commonwealth’s general obligation bonds, which represent approximately 8% of the market value of the high-yield index, according to Barclays. The sales tax (COFINA) bonds are next, at 6%, the Power Authority at 3%, and the Aqueduct and Sewer Authority at 2%. The other Puerto Rico issuers are each less than 2%.

To put the impact of Puerto Rico on the Barclays High Yield Municipal Bond Index into context, not only are those positions big but they also dominate the list (below) of the largest issuers in the index. Entities from Puerto Rico account for five of the top 10 issuers—and three of the top five. It also is noticeable that another three of the top 10 are tobacco settlement bonds.

The largest issuers in the Barclays High Yield Municipal Bond Index, as of July 16, 2015, are:

  1. Puerto Rico General Obligation
  2. Puerto Rico Sales Tax (COFINA)
  3. Buckeye Tobacco Settlement
  4. Golden State Tobacco Settlement
  5. Puerto Rico Electric Power Authority
  6. New Jersey Tobacco Settlement
  7. Puerto Rico Aqueduct and Sewer Authority
  8. United Airlines
  9. Puerto Rico Building Authority
  10. 3 World Trade Center

(Source: Barclays.)

Diverse Outcomes
Many analysts tend to treat the $72 billion in outstanding Puerto Rico municipal debt as a single asset class. But is this method of discussing Puerto Rico munis really representative of overall performance? In looking at the returns of these large issuers this year, it turns out that there have been a wide range of results. Year to date through July 16, the island’s general obligation bonds were down about 8%, and its sales tax bonds were lower, by more than 20%, while the Power Authority and Aqueduct and Sewer Authority bonds were up about 10%, according to Barclays.

The huge difference stems from the fact that Power Authority bonds were already down a lot last year when the issuer initiated restructuring discussions, while the Aqueduct and Sewer bonds are continuing to perform, as cited by Puerto Rico representatives at the investors meeting on July 13. At the same time, the general obligation and sales tax bonds were thought to be “ring-fenced” from a possible restructuring a year ago, but have now drawn concern due to the worsening fiscal situation and recent comments by the island’s governor about its ability to repay its debt.  As is clear by this year’s performance, in many instances different bonds will see prices move based upon completely different information.

So, where does all of this leave portfolio managers with their decision-making? The first question is whether to invest in any Puerto Rico bonds. Some portfolio managers have chosen not to buy them, while others have decided to maintain their positions. If a fund has the Barclays High Yield Index as its prospectus benchmark, investors’ expectations have been set with the objective that the fund will be invested in the municipal bond high-yield universe. Since that index currently has a 23% market weight in Puerto Rico bonds, should a municipal high-yield fund have similar exposure in accordance with its prospectus? Of course, 23% is likely to be considered a high weighting for a fund that is supposed to have portfolio diversification, but is 0% the right number given the expectations of the prospectus that the fund will invest in the broad municipal high-yield market? The logical answer would appear to be that a position size somewhere in between 0% and 23% would make sense given the definition of the investable set in its prospectus.

The second question is what will happen to Puerto Rico’s municipal debt down the road? For all Puerto Rico bonds, there is a reasonable probability that there might be a positive outcome for investors from where prices stand today. For example, the average price of a Puerto Rico general obligation in the index is $69 and the average price for Power Authority bonds is $54, based on $100 par value for each. The current prices are the numbers to use for an investment decision now, rather than par or whatever the value may have been a couple years ago.

Given this setting, with a prospectus-defined investment universe that includes a substantial weighting in Puerto Rico bonds, and the prices where bonds are trading today, it seems logical and appropriate to expect municipal bond high-yield funds to have some exposure to Puerto Rico. For those high-yield muni funds that don’t have any Puerto Rico munis, it is worth considering how they are selecting investments within the high-yield universe. It also is worth asking whether current market valuations represent potential value for investors who have chosen to invest in a high-yield muni fund.

Summing Up
The Puerto Rico situation is complicated on many levels. Currently, there is a tremendous amount of attention being paid to the island’s credit situation by the financial media, U.S. lawmakers, and other government officials. This is really an unprecedented amount of focus for the municipal bond market. As portfolio managers, we have many additional considerations based upon how developments in Puerto Rico have affected our investment universe, and the long-standing prospectus mandates for our portfolios. We will continue to analyze the situation as it evolves, and take the appropriate steps to position our portfolios. 

 

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