Bond Market Perspectives | Week of February 10, 2014
- Puerto Rico is not representative of the broader municipal bond market, as both state and local governments continue to benefit from improving revenues.
- The municipal bond market has so far taken Puerto Rico's downgrade in stride, but lingering risks remain due to individual investors' bias to sell and uncertainty over upcoming Puerto Rico borrowing.
Winter in Puerto Rico
The Caribbean island received cold news last week when both S&P and Moody's downgraded Puerto Rico to high-yield or "junk" territory. S&P, the last to place Puerto Rico on watch for downgrade, was the first to act Tuesday, February 4, 2014, and was followed by Moody's three days later. The threat of a downgrade loomed for much of 2013, driving poor performance as Puerto Rico general obligation (GO) bonds clung to the lowest investment-grade rating from both Moody's and S&P prior to last week's announcement.
S&P cited rising near-term risks over Puerto Rico's ability to adequately service all debt obligations while Moody's additionally mentioned poor economic conditions. Aside from having sufficient cash, or liquidity, to meet its debt obligations, Puerto Rico is suffering from a very weak economy, a woefully underfunded pension plan, and a large debt burden -- all of which have led to the recent downgrade. Both ratings agencies acknowledged steps taken by the new government to address its creditworthiness -- including pension reform initiatives, reduced government spending, and tax changes to boost revenues -- but the negatives outweighed the positives.
The municipal bond market has so far taken Puerto Rico's downgrade in stride as reflected by:
- Municipal outperformance. The broad municipal bond market outperformed the Treasury market over the final three days of last week after S&P's downgrade was announced.The downgrade also did not hamper strong investor demand for the state of Illinois' debt sale, which was five times oversubscribed and suggests the market is treating Puerto Rico as an isolated event.
- No forced liquidations. Fears that investors may be forced to sell the bonds upon the loss of investment-grade ratings never materialized and is unlikely to occur. Most institutional investors have rules in place that allow them to hold high-yield municipal bonds. Although institutional accounts are unable to purchase additional Puerto Rico bonds, a negative for future demand, a wave of institutional selling is unlikely to take place.
- Already depressed prices. Puerto Rico municipal bonds were already priced to reflect a potential downgrade. Puerto Rican municipal bond yields averaged 1.0-1.5% more than the average yield of high-yield municipal bonds, as measured by the Barclays High-Yield Municipal Bond Index. Much of the price adjustment came during a difficult 2013 in preparation for such an event.
Puerto Rico is not representative of the broader municipal bond market, as both state and local
governments continue to benefit from improving revenues. Revenue improvements resulting from
the economic expansion has in turn led to better credit quality metrics and is the primary reason why troubled municipal issuers are the exception and not the norm. Although high-profile distressed municipal bond issuers like Puerto Rico and Detroit are likely to garner widespread attention, the number of municipal defaults declined for the fourth consecutive year in 2013 [Figure 1].
The downgrade had a negative impact on many individual investors and this may create lingering
risks. From Tuesday afternoon, February 4, 2014, when S&P downgraded Puerto Rico, to Monday,
February 10, 2014, roughly 65% of investor trades in Puerto Rico's most liquid GO bonds were
"sells," according to trading data on the Municipal Security Rulemaking Board (MSRB). Renewed
selling by individual investors, an important demand component, may reverse a nascent trend of
three weeks of positive mutual fund inflows following 33 weeks of outflows. Mutual fund flows alone may not move the market but can create a headwind going into a traditionally difficult March to early April seasonal period in the municipal bond market. An escalation of selling may pressure the broader municipal bond market. In the meantime, limited new issuance and taxable bond market strength are helping the municipal bond market.
Puerto Rico is seeking to raise additional cash, in part to help service upcoming debt commitments. Additional liquidity commitments triggered by the downgrades are likely to be met with cash on hand, but some form of borrowing, either through a new debt sale or directly from a bank or other entity, is needed. Puerto Rico is likely to obtain that funding and if done successfully and at a reasonable cost, ratings pressure may be alleviated. Focus will then return to the economy for signs of improvement, which have yet to materialize [Figure 2]. The Puerto Rican Government Development Bank's Economic Activity Index is very closely correlated with economic growth and indicates no reversal of the current recession.
On a positive note, the Puerto Rican Treasury announced higher-than-expected revenues for
December 2013, and in fiscal year 2014, which began July 2013, revenues are $93 million ahead of
budget forecasts. Additionally, the government is expected to announce a balanced budget proposal for the coming fiscal year, ahead of earlier projections. The positives are encouraging but outweighed in the near term by the borrowing need. The improving revenues are a step in the right direction towards ultimately stabilizing credit metrics.
Puerto Rico municipal bonds have largely "priced in" a downgrade but lingering risks suggest that
they remain a higher risk investment and suitable only for investors willing to take such risks. Unlike U.S. states and cities, Puerto Rico is unable to file Chapter 9 bankruptcy and if conditions
deteriorate, in a worst case scenario, the Commonwealth may be forced to undergo a debtrestructuring where investors may receive less than their original principal value in order to reduce the debt burden. Upcoming borrowing, and its success, will determine -- along with economy and incoming revenue -- the next direction for Puerto Rico bond prices.
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
reference is historical and is no guarantee of future results. All indices are unmanaged and cannot
be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges.
Index performance is not indicative of the performance of any investment. Past performance is no
guarantee of future results.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields
will decline as interest rates rise, and bonds are subject to availability and change in price.
Treasuries are marketable, fixed-interest U.S. government debt securities. Treasury bonds make
interest payments semi-annually, and the income that holders receive is only taxed at the federal
Government bonds and Treasury bills are guaranteed by the US government as to the timely
payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed
International and emerging market investing involves special risks such as currency fluctuation
and political instability and may not be suitable for all investors.
The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
Municipal bonds are subject to availability, price, and to market and interest rate risk if sold prior
to maturity. Bond values will decline as interest rate rise. Interest income may be subject to the
alternative minimum tax. Federally tax-free but other state and local taxes may apply.
A general obligation bond is a municipal bond backed by the credit and "taxing power" of the
issuing jurisdiction rather than the revenue from a given project.
High-yield/junk bonds are not investment-grade securities, involve substantial risks, and generally
should be part of the diversified portfolio of sophisticated investors.
The Barclays Capital High Yield Municipal Bond Index is an unmanaged index made up of bonds
that are non-investment grade, unrated, or rated below Ba1 by Moody's Investors Service with a
remaining maturity of at least one year.
The Puerto Rico GDB Economic Activity Index is a monthly report that features a commentary on
the Government Development Bank's Economic Activity Index (GDB-EAI), a coincident index for
the economy of Puerto Rico. The GDB-EAI is a valuable tool that summarizes the behavior of four
major monthly economic indicators. Up to March 2012, these indicators were: total payroll
employment, cement sales, gasoline consumption, and electric power consumption. As of April
2012, the electric power consumption variable was replaced by the electric power generation
variable as the fourth indicator.
This research material has been prepared by LPL Financial.
To the extent you are receiving investment advice from a separately registered independent
investment advisor, please note that LPL Financial is not an affiliate of and makes no
representation with respect to such entity.
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Tracking #1-245418 Exp. 02/15The 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 cannot be invested into directly.
The financial consultants of Wealth Management are registered representatives with and Securities are offered through LPL Financial. Member FINRA/SIPC. Insurance products offered through LPL Financial or its licensed affiliates.
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