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Spreads Narrow for Puerto Rico

Spreads between Puerto Rico general obligation paper and the generic triple-A rated GO sector have narrowed considerably since the beginning of the year and continue to do so.

The growing attractiveness of the commonwealth's paper is due to an overall supply shortage, an increased willingness by investors to buy lower-rated paper, and the debt's unique triple tax exemption, according to market participants.

Even as credit spreads in general remain historically wide, market participants say that Puerto Rico has benefited from overall improving market conditions, and they believe the tightening is evidence of recovery from the negative effects of a sharp decline in municipal prices at the end of 2008 and weakness that flowed into early 2009.

"Spreads have tightened on 'yieldier' credits in the municipal market in the past six months," said Sam Ramirez Jr., a managing director at Ramirez & Co. in New York City, which has a strong presence in Puerto Rico's primary and secondary markets.

"The economy is getting back on its feet and investors' appetite for risk is increasing," he said.

Those factors have been the driving forces behind a nearly 100 basis point tightening in the spread between 30-year triple-B rated Puerto Rico GOs and 30-year generic triple-A GOs since the beginning of the year, according to Municipal Market Data.

As of last Thursday, Puerto Rico GOs due in 30 years yielded 5.67% - 160 basis points higher than the generic triple-A GO scale and its tightest so far this year, after remaining at a steady spread of 165 basis points since June 19, according to MMD.

By comparison, back on Jan. 5, a 260 basis point spread separated Puerto Rico GO bonds due in 30 years, which were yielding 7.63% - the same as the generic triple-B curve that day - and generic triple-A GO bonds, which were yielding 5.03%, according to MMD.

The spread was at its widest at 330 basis points on Jan. 27, where it remained until Feb. 19, when it shrunk slightly to 320.

Meanwhile, the tightening has also narrowed the spread between triple-B rated Puerto Rico GOs and the generic triple-B curve. Triple-B Puerto Rico GOs were five basis points lower in yield than the generic triple-B curve in 30 years, which yielded 5.72% as of last Thursday, according to MMD.

By comparison, that spread was its widest at 106 basis points back on Feb. 11 when triple-B Puerto Rico GOs in 30 years yielded 8.01% and the generic triple-B curve in 30 years was at a 6.95%.

The noticeable narrowing by Puerto Rico bonds in the past six months stems from fiscal belt-tightening by the commonwealth, as well as lower supply in the municipal market in general as tax-exempt issuance competes with ballooning sales of Build America Bonds, Ramirez noted.

The spread tightening is "an indication of investors' confidence in the overall health of municipal credits," he said. "In addition, the triple tax-free status of Puerto Rico bonds creates consistent demand from investors."

"Puerto Rico paper always trades better than its rating due to the 'wild card' value of the tax exemption," agreed Nate Singer, a managing director of Swap Financial Group in South Orange, N.J., who said a period of strong demand for municipals typically causes Puerto Rico spreads to compress.

"Whether you are talking about one of the several GO-backed credits or a revenue credit, like the Puerto Rico Electric Power Authority, investors are generally comfortable with the fact that debt service will be paid on a timely basis and the bonds will always see demand from state-specific buyers," Singer said.

John Mousseau, a senior portfolio manager at Cumberland Advisors in Vineland, N.J., also said the tightening is a result of the dearth of specialty-state supply - particularly because of the swell of BAB issuance - and the growing comfort level among investors for riskier paper.

Last week, $92.5 million of public improvement GO refunding bonds sold by the commonwealth met with strong demand and came at a 103 basis point spread over the triple-A MMD curve in both 2030 and 2031 - considerably tighter than where new issues came back in the first and second quarter.

Morgan Stanley priced the 2030 and 2031 maturities with yields of 4.93% and 5%, respectively.

Insured by Financial Security Assurance Inc., the GO refunding bonds have underlying ratings of Baa3 by Moody's Investors Service and BBB-minus by Standard & Poor's, both with a stable outlook.

By comparison, on June 25 when the Puerto Rico Public Buildings Authority sold $330.9 million of revenue refunding bonds rated Baa3 by Moody's and BBB-minus by Standard & Poor's, the final 2036 maturity was priced with a 6.90% yield - 225 basis points off the triple-A scale at the time, according to MMD.

While credit spreads remain wide in general, Mark DeMitry, vice president and senior portfolio manager at OppenheimerFunds Inc. in Rochester, N.Y., said Puerto Rico's universally accepted status has helped it outperform other bonds in the triple-B market.

"The triple-exemption makes the bonds very desirable and there have been very few lower-rated bonds" available, he said.

"The yields that people are willing to accept on Puerto Rico are lower than some other sectors of the triple-B market, but I think that goes back to the fact that GOs and essential-service bonds have extremely low defaults and people are much more comfortable with the full taxing authority of the territory than just the revenues on a triple-B rated hospital," DeMitry said. "As the risk-aversion starts to abate, the yield differential is starting to compress and Puerto Rico has benefited from that."

On Sept. 17, 2008, the spread between triple-B GO bonds and triple-A GOs was 92 basis points, after starting the year at a spread of 82 basis points. On Jan. 2, 2009, the spread was 258 basis points and as of last Thursday the spread was 165, according to MMD.

DeMitry said the firm manages 18 municipal portfolios, and is overweight on Puerto Rico debt.

"In general, credit spreads between triple-A and lower triple-B bonds, like Puerto Rico, remain wide relative to historic averages, but with the low default rate and triple exemption, that offers a very good risk-reward proposition" on Puerto Rico GOs, DeMitry said.

Meanwhile, budget-balancing efforts by the new administration is helping to strengthen the credit quality of the GOs' pledge and keep yields down relative to the triple-B sector, analysts said.

"The government is in the process of implementing drastic reforms and cuts to payroll, which lends a lot of stability to the credit, and is part of the rationale of how the bonds are pricing," said Horacio Aldrete, a director and the primary analyst for Puerto Rico at Standard & Poor's in Dallas.

The rating agency has maintained its BBB-minus and stable outlook on the commonwealth since 2007, he noted. He said continued cost-cutting measures and remarketing of outstanding debt to eliminate exposure to fluctuations in variable-rate interest rates - which is what last week's GO refunding accomplished - helps keep the credit in a positive light and boost its image among investors.

Meanwhile, Fernando Batlle, executive vice president of financing and treasury at the Government Development Bank for Puerto Rico, said: "Any narrowing of spreads helps us to get a better cost of funds for any of the commonwealth of Puerto Rico issuers, including COFINA."

The commonwealth does not anticipate issuing in fiscal 2010 its yearly GO sale, which carries triple-B ratings. Instead, the island is tapping into its double-A rated Puerto Rico Sales Tax Financing Corp., known as COFINA using its Spanish acronym, to help balance its fiscal 2010 budget and to support a $500 million local stimulus plan.

Michelle Kaske contributed to this story.

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