Credit spreads on Puerto Rico bonds have widened dramatically in recent weeks compared to similarly rated municipal bonds that have seen spreads shrink as investors bottom-fish for yield among lower-rated securities.
Alan Schankel, a managing director at Janney Capital Markets, released a report this week showing that the yield differential between Municipal Market Data indexes that track Puerto Rico general obligation and generic Baa-rated bonds has significantly widened in the past month.
The spread between yields of 30-year Puerto Rico GOs and comparable maturities of generic Baa-rated bonds has grown by as much as 30 basis points since July.
In a report last month, Schankel had warned investors to limit their exposure to Puerto Rico’s bonds, highlighting the commonwealth’s massive debt, underfunded pension liabilities, and sputtering economic recovery.
Puerto Rico’s GO bonds are currently rated Baa1, BBB and BBB-plus by Moody’s Investors Service, Standard & Poor’s and Fitch Ratings, respectively.
With its financial problems, Puerto Rico’s GO credit spreads — even with yields about 200 basis points above the triple-A benchmark — did not adequately reflect bondholder risk a month ago, according to Schankel.
At the time, those spreads were about 20 basis points above generic triple-B yields in 10- and 30-year maturities. But in the intervening three weeks, Schankel said, that gap has widened to as much as 50 basis points. From the beginning of the year, it has widened by 70 basis points.
“Although we continue to caution against overconcentration in Puerto Rico credits, given its fragile economy and high debt load, the risk-reward proposition, particularly for general obligation and commonwealth guaranteed issues, has improved,” Schankel said.
In the broader market, credit spreads on similarly rated bonds have been narrowing.
On Wednesday, the five-year triple-A to triple-B MMD spread had compressed to 149 basis points from 169 basis points during August. The spread has come down much more since the beginning of the year, when it started at 193 basis points.
The 10-year triple-A to triple-B spread was 163 basis points on Wednesday — 26 basis points lower than from the beginning of the month, and 40 basis points from the beginning of the year.
The 30-year spread did not drop quite as much, but still fell. On Wednesday, the spread was down to 148 basis points from 167 basis points on Aug. 1 and from 162 points on Jan. 3.
Steve McLaughlin, executive director and portfolio manager at R. Seelaus & Co., pointed to Puerto Rico’s financial problems as reasons behind the widening spreads, which he said have been steady and gradual.
“Puerto Rico’s pension issues that they’re fighting and their liquidity concerns have been documented now for over a year, and there has been less and less retail interest in the product,” he said. “In the past year or two a lot of the [separately managed accounts] have been cutting their exposure to the credit.”
The demand component of institutional investors has also been diminishing, and will likely continue to do so.
“For the institutional community the price performance of Puerto Rico paper is not there,” McLaughlin said. “High-yield bonds are tightening right now, and Puerto Rico’s are actually widening. So those bonds can’t perform well in an institutional portfolio,” he said.
In the past year, Moody’s has downgraded Puerto Rico’s GO bonds to Baa1 from A3, with a negative outlook, and Standard & Poor’s has placed its BBB rating on negative outlook. More recently, S&P said it could downgrade the commonwealth’s pension bonds if measures aren’t adopted to address the pension problems.
Many reports on Puerto Rico’s financial woes have been released in the past year or two, causing investors to evaluate whether the reward from buying the island’s bonds matches the risk.
McLaughlin likens it to lifting up the hood of a car, trying to understand how it really works, and asking: Is that a car you really want if you have other options?
“It comes down to the individual buyer and what their fundamental analysis is of the underlying ability for Puerto Rico to fix or contain their pension obligations and what that rate of interest should be for that calculated bet,” he said.
McLaughlin expects that Puerto Rico’s spreads will continue to widen.