It is always exciting when an investment suddenly becomes available at fire-sale prices. Separating the human tragedy wrought by Hurricane Maria, prices of municipal bonds issued by Puerto Rico — on the surface — look downright cheap. But they are not.
It is no secret that the commonwealth was in financial trouble long before the hurricane wiped out the island’s infrastructure. In May, Puerto Rico asked for what was essentially bankruptcy relief in federal court. It was the first time that an American state or territory took such a step.
The island’s bond prices plummeted. And its approximately $72 billion in debt dwarfed the $18 billion bankruptcy filed by the city of Detroit in 2013.
Puerto Rico Bonds Currently in Default
Finally, it missed its interest payments due in July, putting its bonds into technical default. Can it make good at all? Not likely. The economic base normally drawn from for tax and fee revenues is almost non-existent. Even before the hurricane, the poverty rate on the island was 45%, according to the U.S. Census Bureau.
Then there are the current owners of Puerto Rico bonds. A large portion of the debt is held by hedge funds, nicknamed “vultures.” They swoop in to buy distressed asserts and use every means possible, including the courts, to extract whatever value they can. Profit is their only motive and their interests do not align with those of the island or its people.
Most municipal bond mutual funds sold their holdings long ago so there is no real institutional “hedge” to stabilize the market. The bonds are still in the holdings of several exchange-traded funds (ETF). According to sponsor data as of Oct. 18, Puerto Rico bonds made up 4.2% of SPDR Nuveen S&P High Yield Municipal Bond ETF (NYSEARCA:HYMB) holdings, while PowerShares New York AMT-Free Municipal (NYSEARCA:PZT) reduced its total exposure to the island to 2.3%.
Further, most bonds here are general obligation (GO) bonds that are backed by the “full faith and credit” of the commonwealth. Typically, that is a positive point as municipalities can raise taxes as needed. However, that’s not an option here. Puerto Rico’s debt represents nearly 70% of the its gross domestic product (GDP).
Making the situation worse for investors, there are few non-GO bonds, or revenue bonds. These are issued by the commonwealth on behalf of itself or private companies to finance projects deemed to be for the public good. Revenue bonds are backed by the revenues of the project, which can include toll bridges, highways or sports stadiums.
Essentially all debt is the responsibility of the government.
Long-Term Price Decay
A chart of the most active bond in today’s market shows the deterioration of prices since it was issued in 2014. The Puerto Rico Commonwealth GO 8.00% due 07/01/2035 currently trades at about 32.50 on a scale of 0 to 100. In other words, each $100 of face vale is now priced at $32.50. And its yield to maturity is about 25.3%. Compare that to a long-term U.S. Treasury bond at 2.8%.
Click to EnlargeWhile that seems to be almost 10 times the yield potential, the trend in the price of this bond is still down. Bond traders tell me it will only be a decent risk at 20 or 25.
In other words, they see a potential loss of 23-38% from current levels. That would wipe out any potential gain if — and that’s a big if — the bond pays off at maturity in the year 2035.
Will It or Won’t It?
Technically, the trend is clearly to the downside and any speculative value here is likely limited to the proverbial “dead cat bounce,” which is only a short-term opportunity.
Whether the bonds will ever make an interest payment again, let alone return principal value at maturity is still a big question. I suspect this is a risk only professionals should even consider and, even then, only when the price is ridiculously low. It is not there yet.
As of this writing, Neil Martin did not hold a position in any of the aforementioned securities.
