Puerto Rico Credit Spreads Continue to Widen

In the past three months, credit spreads on Puerto Rico bonds have continued to widen, improving the risk-reward proposition, according to a recent report from Alan Schankel, managing director at Janney Capital Markets.

Puerto Rico general obligation bond yields are now 225 basis points above triple-A benchmark yields in 30 year maturities and 270 basis points higher in 10 year maturities.

“A likely reason for tighter spreads on the longer maturities is the concentration of mutual fund and other long duration investor demand,” Schankel said.

The report, released on Thursday, comes three months after a July 27 report in which Schankel warned investors to limit their exposure to Puerto Rico’s bonds, highlighting the commonwealth’s massive debt, underfunded pension liabilities, and sputtering economy.

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 earlier this year, according to Janney’s July report.

As yields have crept higher in recent months, the risk better matches the reward, though Schankel still warns investors to be cautious.

“We continue to advise against over concentration in Puerto Rico municipal bonds, but given the recent spread widening, investors with low current exposure to commonwealth debt, and appropriate risk tolerance may consider taking positions in the 10-year range, where the risk-reward balance is most favorable, although it is best to await results of next week’s election for more clarity,” he said.

On Nov. 6, Puerto Rico’s voters will determine whether Gov. Luis Fortuno, a Republican, serves another four years.

Fortuno’s administration has implemented aggressive and painful reforms to improve government finances, including significant reductions in the number of government employees and narrowing of the government’s persistent budget gap, Schankel said.

“An argument can be made that bond investors will react positively if he is re-elected but will have a more uncertain view and investment approach if his primary opponent, Alejandro Garcia Padilla wins the governorship,” the report said.

According to an Oct. 9 poll by El Nuevo Dia, a Spanish-language daily, Padilla led the current governor 41% to 39%.

Schankel’s report also noted that Puerto Rico’s economy has stabilized in recent months, with flat or slightly positive annualized growth in every month since December 2011, according to an Economy Activity Index.

The index is comprised of the four monthly economic indicators of payroll employment, cement sales, gasoline consumption and electric power generation, and is provided by Puerto Rico’s Government Development Bank.

In addition, sales tax collections on a trailing 12-month basis are at the highest point since collections began in November 2006, according to the report.

“Although there are modest improvements in economic indicators, the island economy remains distressed,” Schankel said.

“Positive actions undertaken by the current administration have alleviated some pressures, but further reforms are critical, if creditworthiness is to improve.”

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