In the absence of real market-moving economic data, at least until the October employment number is released, the fixed-income market continued to enjoy a firm tone this week. Yields on the 10-year and 30-year Treasuries appear well-anchored around 2.50% and 3.60%, respectively.

This week’s supply surge prevented municipals from fully participating in the Treasury rally. Nevertheless, tax-exempt yield levels were able to decline to three-month lows. At least as of Thursday night, muni ratios in the 10-year and 30-year range continued to look attractive at 100% and 113%, respectively.

The strong muni rally looks all the more impressive when one considers that outflows from municipal bond mutual funds have kept up for a 22nd straight week. According to Lipper, the funds that report flows weekly recorded outflows of $746 million for the week of October 23rd.

While the market pressure on Puerto Rico may have abated for the time being, the political and regulatory backlash may just be starting.

Market observers also point to the major muni ETFs’ narrowing discount to their underlying net asset values as a sign that investors are increasingly comfortable with the outlook for the sector. Of course, it could also be the case that the marks on the ETFs’ holdings are finally catching up with the true market levels.

What’s Next for Puerto Rico?

The jury’s out: the Commonwealth’s investor call last Tuesday was extremely successful in stopping the free-fall in PR bonds. The COFINA bonds, in particular, have rebounded spectacularly, now that potential “clawback” concerns have been allayed by the PR financial team. The First Subordinate Series 5 ¼% in 2041 have rallied a stunning 150 basis points to 7.10% since the call, having traded in size at as low as an 8.60% yield. In dollar price terms, this translated into about a 20% gain in just over a week. Of course, even at these levels, the proposed Second Subordinate (or third lien) bonds would still have to be priced in the 8.00% range, so we’re still quite a way from Treasurer Acosta Febo’s 7.00% target. Perhaps in another week or so?

Since much of the speculative buying interest over the past few weeks has been driven not so much by yield, but by the attractive dollar prices in the 60-70 range, it’d be interesting to see if the current rally can hold up once prices go beyond that range.

With the new marginal buyers of PR paper consisting of hedge funds and distressed investors, trading volatility could become the norm going forward, in both directions.

In the meantime, it’s fair to say the irrational fear factor that has been hammering the PR market since the Barron’s article is now over. The Padilla Administration has bought itself a little time to turn around the local economy. Having said that, the market’s patience is bound to be limited, perhaps no more than a few months. If PR’s economic indicators don’t show clear improvement by the end of the first quarter, we could be right back where we were a month ago.

At the end of the day, one can’t help but wonder if Puerto Rico didn’t just miss a historical opportunity to restructure its debt once and for all and put itself back on the path to economic growth again. Imagine if the Commonwealth could persuade its bondholders, who have already taken the market value hit, into a three-year debt service moratorium and use the savings to reduce the size of government and actually cut corporate taxes? Now that could give the island’s economy a big shot in the arm. But that scenario could never happen, could it?

While the market pressure on PR may have abated for the time being, the political and regulatory backlash may just be starting. Over the past two days, separate articles from the Wall Street Journal, Bloomberg News and The Bond Buyer all highlighted why “Wall Street,” the muni funds and the rating agencies should all share the blame for the massive increase in PR’s deficit financing debt over the past few years. Wall Street banks have been able to charge much higher fees for the Commonwealth’s increasingly complex transactions. The mutual funds, of course, only care about the triple tax-exempt income. And, last but not least, the rating agencies have been all too willing to give PR the benefit of the doubt even as the deficit financings were piling up.

In fact, Standard & Poor’s just re-affirmed PR’s “BBB minus” rating yesterday, even as the market continued to price it at around a “B” level. Interestingly, one of S&P’s own subsidiaries, CMA (now part of S&P Capital IQ), is estimating an eye-popping 77.59% default probability for the island based on credit default swap (CDS) levels, higher than even Argentina. We did ask for an explanation from the CMA folks but have yet to hear back from them. We suspect this rather silly report may have had more to do with CMA’s methodology of deriving default probabilities from CDS quotes than with anything more fundamental. As many researchers in academia can attest, it’s always a challenge to derive an accurate default probability from either credit spreads or CDS quotes.

The regulators are finally catching on to the potential market implications of a PR credit crisis. Yesterday, the Bond Buyer broke the story that the Securities and Exchange Commission (SEC) is conducting nationwide, “limited scope examinations” of certain mutual funds that invest in Puerto Rico securities.

For what it’s worth, we would lay the blame for PR’s current fiscal woes squarely on the triple tax exemption benefiting PR bonds. To us, this is just another instance of tax policy distorting the capital allocation process and getting in the way of proper risk pricing. Arguably, without the triple tax exemption, the market would never have let PR get this far out on a fiscal limb. Tax exemption always seems to give investors an excuse to overlook credit fundamentals (this also happens frequently in the high yield muni market, by the way). Given where PR credit risk is being priced relative to other emerging market credits, perhaps it is time for PR to compete for capital in the global markets, with or without the artificial subsidy by the U.S. Tax Code?

We do understand and agree with the public policy goals of helping U.S. Territories access the municipal market. However, we believe such tax advantages should really be limited to debt issued for infrastructural projects and disallowed for deficit financings. Perhaps in the fullness of time, the whole tax issue will be resolved along with the Commonwealth’s political status?

Ironically, funding for a new plebiscite regarding PR’s statehood has reportedly been cut as a result of the current budget wrangling in Washington. In many ways, Puerto Rico’s economic and political future may depend on factors well beyond its control.

Disclaimer: The opinions and statements expressed in this column are solely those of the author and Axios Advisors, who are solely responsible for the accuracy and completeness of this column. This column does not reflect the position or views of RICIC, LLC or MuniNetGuide.

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