[Editor’s Note: Due to new constraints on Triet Nguyen’s schedule, Muni Bond Insights will now be published once a week on Wednesdays]

All it took was an extremely dovish testimony by incoming Federal Reserve chairperson Janet Yellen and a shockingly bipartisan resolution to the debt ceiling issue to restore the equity market’s faith in the nascent US economic recovery.

At least for now, the risk trade is back on, which also put an end to the flight-to-quality that has buoyed the fixed-income markets over the first six weeks of this new year. The benchmark 10-year Treasury bonds could not stay below the 2.60% mark for very long and is now threatening to re-test the 2.80% level once again.

With virtually no supply to speak of this week (a mere $2.65 billion in primary market offerings), muni market participants have had plenty of time on their hands to focus on Puerto Rico. And there has quite a bit of news to chew on. Just consider the list of events that have transpired over the last week:

First, to no one’s surprise, both Moody’s and Fitch have joined S&P in downgrading Puerto Rico and its related instrumentalities to below investment grade. What was surprising was the fact that Moody’s and Fitch went a bit further than S&P by knocking the G.O. rating down by two notches, not just one. So far, Moody’s has proven to be the most aggressive of the three agencies: first, it was the only one to go after Cofina, taking the first lien and second lien bonds down to Baa1 and Baa2, respectively; and secondly, it also downgraded PREPA to Ba2 from Baa3, citing the Authority’s historical dependence on loans from the GDB (and putting a little dent in the argument that PREPA should be viewed as self-supporting).

With virtually no supply to speak of this week … muni market participants have had plenty of time on their hands to focus on Puerto Rico.

Meanwhile, the economic news continues to be dismal: after showing signs of stabilizing between September and November, the GDB Economic Activity Index resumed its descent in December, with a 1.0% month-to-month decline and a 5.2% year-over-year drop.

Another major development with the potential to further confuse the markets is the prospect of tax reform in PR. As we discussed in a previous article, the Padilla Administration is reportedly reviving an old proposal dating back to the Calderon days to replace the Sales & Use Tax (SUT) with a Value-Added Tax (VAT). A VAT’s appeal is fairly obvious: aside from being easier to enforce, with less potential leakage to the underground economy, this new tax will also replace the controversial Act 145 excise tax, scheduled to sunset in 2017.

Understandably, this latest news has caused a bit of concern among Cofina bondholders, although the Commonwealth has gone out of its way to reassure them that, by statute, they will made whole from a security standpoint. How that might be accomplished from a legal standpoint is easier said than done, however: for instance, would the tax substitution require a constitutional amendment? We can only wonder.

Against this backdrop, it’s probably not surprising that, after months of touting Cofina (and/or its local version, Cofim) as the preferred financing option, the Commonwealth has made an about-face and decided to issue up to $3.5 billion G.O. bonds instead. Aside from preserving the Commonwealth’s future flexibility with regard to tax reform, there may have been additional concerns about relying on a source of revenues that may underperform due to the weak underlying economy. In fact, over the past 7 months, SUT collections have grown only 6%, despite an expansion in the tax base designed to generate 25% more in revenues. At the end of the day, Commonwealth officials probably also realized there’s a limit on how much you can leverage the same revenue source, third lien or not.

Which gets us to the question we posed in today’s title: has PR’s risk profile and financing needs gone well beyond the capacity of the US municipal market? We believe the answer has to be “yes.” Although forced selling by the mutual funds has yet to materialize, the fact of the matter is there is very limited capacity left for PR paper among the traditional muni buyers. Even if some of the high yield mutual funds could find room to add to their PR holdings, they may choose not to do so for business reasons. Since last summer, PR exposure has become as much of a business risk than an investment risk for many of these institutions.

Thus, the bulk of the potential interest in the upcoming bond issue must come from hedge funds as well as overseas buyers. In this context, it may make sense to evaluate PR against other “emerging markets” alternatives. Marc Joffe of Public Sector Credit Solutions made a similar argument in a recent article: “Hedge funds and certain other classes of investors can traverse multiple markets. Further, Asian investors have accumulated billions of savings and remain on the lookout for alternatives to low yielding US Treasuries. So the constituency for Puerto Rico debt is not merely the $3.7 trillion municipal market, but a much larger audience especially if the price is right.

Puerto Rico debt is now trading at yields much higher than that of Italy, Spain and Portugal – and is roughly on a par with Greece. In contrast to Greece, Puerto Rico is not a serial defaulter. In fact, it is part of an asset class – US state and territorial bonds – that has not seen a default in over 80 years. Further, the last default – of Arkansas in 1933 – ended in a full recovery for investors. So, from an international perspective, Puerto Rico bonds appear to offer good relative value.”

… has PR’s risk profile and financing needs gone well beyond the capacity of the US municipal market?

Certainly, from a risk standpoint, PR may also belong to the emerging markets category. A recent report dated February 3, 2014 from Moody’s Analytics, a group separate from the ratings team, points out that “market-based probabilities of default for Puerto Rico have continued to deteriorate since the beginning of the year. The Commonwealth’s five-year cumulative CDS- implied EDFTM (Expected Default Frequency) credit measure, for example, rose from 15.86% on December 31 to 20.81% this past week. Puerto Rico’s one-year EDF measure is currently 4.63%, exceeding that of all US states and sovereign entities in our data set except Argentina and Venezuela.

In addition, the difference between Puerto Rico’s one-year and five-year annualized CDS- implied EDF measures has inverted in recent days (…) An inverted yield curve may indicate that investors are concerned about an issuer’s near-term refinancing risk. In that case, an issuer’s debt often begins to trade based on a dollar price that indicates an expected recovery rate, rather than on a yield spread linked to a particular maturity.”

Before you make too much of these CDS-based probabilities of default models, consider this interesting little discovery, courtesy of our friends at Kamakura Corp., a leading risk management consulting firm: their analysis of CDS trade data from 2010 though 2013, as reported by the Depository Trust & Clearing Corporation (which clears all such trades), revealed that “Puerto Rico credit default swaps have never traded in any week since the DTCC began reporting weekly on trading volume beginning with the week ended July 16, 2010.” In other words, none of the comments made in the financial media about CDS spreads on Puerto Rico is based on actual trades, since there hasn’t been any. Such comments are probably just based on inter-dealer quotes which, apparently, never resulted in real trades. This is worth keeping in mind the next time you see muni CDS levels quoted in the press.

With the new financing starting to take shape, the Commonwealth has postponed its investor webcast, originally scheduled for today, to next Tuesday, February 18. By then, it should have more details about the bond issue to communicate to the market. In the meantime, we do know that the deal will be lead-managed by Barclays, RBC and Morgan Stanley, i.e. the same three shops that have been rumored to be shopping around for a deal. We’re also hearing rumors of a $50 million minimum per order, a requirement meant to keep the deal out of retail investors’ hands, and for good reasons.

The Commonwealth’s last investor call, back in October, succeeded in stopping the freefall in PR bonds, at least for a while. For the sake of current bondholders, let’s hope Tuesday’s call will accomplish the same results.

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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