Puerto Rico Municipal Debt: Sunny Paradise or Tropical Storm?
Either Way, a Tactical Opportunity May Exist
There's a lot of talk about Puerto Rican municipal debt recently.
Recent downgrades amid new bond issuance have created a market imbalance, which we believe presents a low-risk tactical opportunity through investing in shorter maturity debt.
Puerto Rico Risk Is likely Insulated
Our belief is that the negative press of the commonwealth has not spilled over onto the broader muni asset class. The broader municipal market has been on the mend and has recovered on the back of expectations for stronger U.S. economic growth, improving U.S. credit fundamentals, and municipalities controlling their costs across the country.
The improvement of property tax revenues has also been a boon to municipal markets given the rise in real estate values since the crisis according to the Securities Industry and Financial Markets Association
Volatility in recent months stems from the series of credit downgrades of the debt, along with the need for Puerto Rico to access the credit markets to improve its balance sheet and secure timely payments on its debt. The subsequent increase in yield created demand from crossover investors such as traditional municipal, hedge fund, and high yield managers. Puerto Rico's latest issuance was successful, as the intended issuance of $3.0 billion increased to $3.5 billion given outsized demand for the issue.
Past performance is no guarantee of future results. Does not reflect the performance of any Principal product. Investors cannot invest directly in an index. Period of 9/30/13 – 3/31/2014 marked by tremendous price and yield volatility.
Why the Market Imbalance?
Downgrades (coupled with anticipation of how well the latest issuance would be received) created a market imbalance. We felt that the success of new issuance was imminent, but the market's perception was not quite as certain, creating a short-term market imbalance.
Short-maturity issues (within two years) traded as cheap as yields greater than 10 percent. We believe this opportunity could be exploited by purchasing these levels.
We also believe that the commonwealth will not have to re-tap the market for financing for another one to two years given the cash infusion from this deal. As such, we believe these issues are "money good" — they have the highest likelihood of principal repayment, which generally represents a low-risk opportunity for high yield.
Longer-Term Concerns Remain
Puerto Rico has bought some time due to the latest issuance and continues to kick the can down the road, which may enable investors to reduce risk by decreasing long-dated exposure, where solvency remains questionable, while simultaneously increasing opportunity by ramping up short-dated exposure.
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The opinions expressed are those of Principal Funds and may not come to pass.
Investing involves risk, including possible loss of principal.
Fixed-income investments are subject to interest rate risk; as interest rates rise their value will decline. Lower-rated securities are subject to additional credit and default risks.