Concerns about Puerto Rico’s credit outlook have intensified in recent months, evidenced by the dramatic underperformance of its bonds during a period of strong inflows into the municipal sector, according to a special report from Axios Advisors, an independent research group, entitled Post-Election Puerto Rico: Systematic Risk or High Yield Opportunity?
Interest in Puerto Rico debt is exempt from federal, state, and local taxation, making it an attractive investment for municipal bond investors and their proxies, the mutual funds. However, the Commonwealth’s fiscal affairs and, more recently, the controversial issue of its potential statehood have caused trepidation among investors.
In this report, co-authors Carol Karsten and Triet Nguyen acknowledge the Commonwealth’s obvious credit weaknesses. However, they explain why they believe that its credit should remain an investment grade credit, albeit at the lowest level.
“Puerto Rico bonds are somewhat unique in that the Commonwealth is a sovereign entity with full taxing power and no legal right to file for bankruptcy. Both of these factors bode well in terms of credit risk,” says Nguyen. “On the other hand, Puerto Rico has some inherent credit threats, including the lack of diversity in its local economy, and the still remote possibility of statehood, which would impact its tax status.”
The report, which was designed to address “market anxiety” over this high yield credit also discusses the demographic and labor force composition of Puerto Rico, which closely mirrors that of the U.S., as well as the Commonwealth’s Health Insurance Administration (“Mi Salud”). Both of these factors could also have a significant impact on Puerto Rico’s economic well-being going forward.
On the technical side, most national municipal bond mutual funds can include debt from any state to achieve geographic diversification, while so-called state-specific funds lack the same “luxury” of choice, Nguyen explains. Puerto Rico bonds can help these funds, which fill in the gaps with bonds issued by U.S. territories and the Commonwealth. It may be possible that Puerto Rico’s penetration in the U.S. municipal bond market may have reached its saturation point.
“This convergence of fundamental and technical issues is at the heart of the Puerto Rico dilemma… There is no doubt that Puerto Rico has become the muni market’s single largest high yield issuer.”
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