They may be outliers but they are satisfying the hearty demand from some yield-starved investors.

Analysts and portfolio managers say there is opportunity in paper from Puerto Rico and California, two places struggling with challenges that range from closing budget gaps and controlling spending to legislative hurdles and pension issues.

“People are tripping over themselves to find yield, and Puerto Rico and California credits will give you yield,” said Tom Dalpiaz, senior vice president of Advisors Asset Management, which oversees $310 million of municipal debt in separately managed accounts for high-net worth retail clients in 29 states.

“They are the poster children for the perennially challenged credits of the municipal market,” he said. “They are always seemingly in and out of intensive care.”

Experts said yields would be even higher if it weren’t for the market’s willingness to pay up for the paper in light of investors’ keen interest in yield and the overwhelming need for bonds in the midst of the spring reinvestment season.

“Rates are low and investors are reaching for those few bonds that offer high yields,” said Eric Friedland, head of municipal research at Schroder Investment Management. “If current conditions see interest rates remain low in all fixed-income markets, and overall municipal issuance remains low, I believe there will be demand for high-yield paper, such as Puerto Rico.”

Dalpiaz said heavy demand bodes well for high-yield credits in the current market. “This is good news for Puerto Rico and California because they can get fairly inexpensive yields in order to clear the market,” he said, adding that “the fundamentals are very strong right now” because of the reinvestment season in the next 30 to 45 days.

On the other hand, Dalpiaz said while the credits are attractive, they are not trading “as cheap as they should without all the extra demand.”

Friedland said it is an anomoly.

“There is a disconnect between the market’s perception and how they are trading,” he explained, agreeing with Dalpiaz that Puerto Rico is “probably trading tighter than it should be at this point.”

As a result, he prefers California paper to that from the commonwealth, which is still working to close operating deficits and improve an economy struggling to exit a six-year recession and under-funded public pensions.

Gov. Luis Fortuno, who is seeking a second term in November, has cut some 20,000 government jobs and reduced Puerto Rico’s yearly deficit by 90% to a projected $333 million in the next fiscal year

“The governor was able to implement revenue increases, but they are short-term in nature,” Friedland explained. “Where California has gotten better, we haven’t seen much improvement in Puerto Rico. With the demand being so high, every time Puerto Rico comes to market, the yields are lower than we feel they should be for a credit such as this.”

Still, investors are whetting their appetites with the spreads that they see as enticing when compared to the generic triple-A general obligation scale. On Monday, the 30-year GO was yielding a 3.05%, according to Municipal Market Data.

Dalpiaz said triple tax-exempt Puerto Rico is at the top of his list when it comes to yieldy paper, followed by California and Illinois.

For instance, he purchased Puerto Rico Public Building Authority revenue bonds with a 5¼% coupon due in 2013 at a 1.36% yield, which was 116 basis points higher in yield than higher-quality generic triple-A GO paper when he made the purchase two weeks ago. The bonds are backed by a commonwealth guaranty.

In addition, he also bought building authority bonds with a 5¾% coupon due in 2017 at a 3.10% yield — 234 basis points above the MMD high-grade scale at the time. The PRPBA bonds are rated Baa1 by Moody’s Investors Service and BBB by Standard & Poor’s.

Dalpiaz said he has seen the short end of the Puerto Rico market as wide as 250 basis points over the high-grade scale. “It offers nice additional spread for a short maturity on something that we think will ultimately honor its obligation,” he said.

In California, the spreads are tighter but  still attractive, Dalpiaz noted.

He recently bought California State Public Works Board annual appropriation bonds rated A2 by Moody’s and BBB-plus by S&P with a 5% coupon due in 2014 at a 1.13% yield — 82 basis points above the MMD high-grade scale in two years.

“In California, for something you are comfortable with, it’s hard to find plus 82,” he explained. “There is some value, but you have to tread carefully.”

Dalpiaz said he keeps exposure to the credits at a minimum — typically under 5% — and keeps maturities between five and seven years, or less, in order to control volatility while still picking up some attractive spreads on Puerto Rico, California or Illinois paper.

He finds most of his value and diversity in the secondary market, but said he keeps an eye on new issues as well.

Friedland, meanwhile, said even though California is in much better shape than it was two years ago because it modestly lowered its budget gap and cured some fiscal impediments, its unique structural challenges, economy, proposed voter initiatives and tax issues make it a likely candidate for yieldier paper.

“All of these things combined have created a situation in California that limits their ability to achieve the highest rating,” he said. “You have volatility in California that you don’t see in other states.”

Friedland, too, agreed that paper from the state is vulnerable to seasonal spread volatility. “If the budget is late, then spreads widen out because of the fear in the market,” he said. “There will be volatility from June 5 to June 30 when the budget has to be approved.”

“This budget will have lower issuance than prior years and that would drive spreads tighter,” he added, whereas spreads typically tighten in the fall when issuance picks back up again after the sluggish summer season.

Friedland said investors can take advantage of these inefficiencies to earn more yield, especially when interest rates are low and heavy redemptions are outpacing new issuance in some states. “California is in favor because there is a scarcity factor,” he added.

Like Friedland, Dalpiaz said spreads often widen when there is increased budgetary woes and tighten when the headline risk subsides, making for a slippery slope in the market of high-yield credits.

“As an investor, you have to be willing to deal with the roller-coaster risk,” he said. “They have to make tough choices with budget issues, and there is a lot of fear and noise in the meantime. You have to be willing to absorb that risk.”

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