For those investors hoping to take advantage of the plump yields on Puerto Rico's debt, the municipal bond team at Janney Montgomery Scott has some advice: Be careful.
Puerto Rico's bonds are teetering at a dangerous precipice, Janney warns in a report published this week.
The yield on the 10-year Puerto Rico general obligation bond has skyrocketed to 6.24%, a leap of almost two percentage points in the past year, according to Municipal Market Data.
The commonwealth, which has four million people, faces a $3.2 billion budget deficit and a projected four-year recession.
The unemployment rate has surged to 13.5% and the island's pension system is severely underfunded.
Kevin Lynch, municipal analyst at Janney, wrote that the government has little room for error. Puerto Rico's $12.9 billion of GO debt and $1.3 billion of appropriation debt are susceptible to downgrades, he said.
Moody's Investors Service rates Puerto Rico's GOs Baa3 and Standard & Poor's rates them BBB-minus. Both have a stable outlook.
Still, Guy LeBas, director of fixed-income strategy at Janney, said Puerto Rico's credit rating is at the edge of a cliff.
A downgrade of even one notch from either agency would push Puerto Rico off that cliff and into junk status. That would trigger a flight from Puerto Rico's debt because of the stigma of owning sub-investment grade bonds, LeBas said.
The spread of a typical junk muni over a triple-B muni is 290 basis points, he said.
To some extent, the market has already prepared for a downgrade by clobbering Puerto Rico's bonds.
"At the same time, the actual event [of a downgrade] would almost certainly cause further depreciation," LeBas said.
Fernando Battle, executive vice president at the Government Development Bank for Puerto Rico, said the GDB is "committed to take the necessary measures to prevent a downgrade, since this would have a terrible impact on our economy."
Battle said the commonwealth is confident it can stabilize its finances and satisfy the rating agencies.
The jump in yields on Puerto Rico's bonds coincides with a significant contraction in yields for high-grade munis.
Based on the MMD yield curve, the 10-year Puerto Rico bond a year ago yielded less than a percentage point more than the triple-A benchmark muni. Today, the spread has swelled to 340 basis points.
Puerto Rico's economic travails hamper many of its major municipal issuers, according to a Janney report yesterday.
Government agencies like the Puerto Rico Infrastructure Financing Authority and the Puerto Rico Highway and Transportation Authority have a dangerous weakness, Lynch said: The government can intercept part of their revenues to pay of its own general obligation debt.
Other agencies, like the Puerto Rico Public Buildings Authority, are too closely tied to Puerto Rico's GO credit because some of their debt is guaranteed by the commonwealth, Lynch said.
Because Lynch is cautious about Puerto Rico, he is cautious about these underlying credits. One major issuer he likes is the Puerto Rico Sales Tax Financing Corp., which has $5.2 billion of debt. Sales tax financing bonds are secured by a 1% sales tax, part of the commonwealth's 5.5% sales tax. Puerto Rico plans to increase the the sales tax dedicated to the corporation to 2 %.
"It's unlikely that P.R.'s sales tax revenues will decline substantially enough to create a threat to debt service payments," Lynch said.
