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Puerto Rico Sovereign Debt Downgrade?

Time may be ripe soon to buy Puerto Rico bonds

Inquirer.com Tuesday, February 4, 2014, 1:08 AM

Wall Street is starting to treat Puerto Rico’s municipal bonds as if they have already been downgraded to “junk” status. But what does that mean for our portfolios?The news is grim for the island commonwealth. Due to budget deficits and unfunded pension liabilities, the Moody’s, S&P, and Fitch rating agencies rate general obligation bonds issued by Puerto Rico at the lowest investment grade. The agencies have hinted at downgrades to below-investment grade, also known as “junk,” possibly within 30 days.

Why do we care? Roughly 70 percent of U.S. muni bond mutual funds hold Puerto Rico debt, which is tax-exempt. A downgrade to junk may prompt massive selling because some money managers can’t buy securities rated below investment grade.

The upside to Puerto Rico bonds is that they offer tasty yields. Since the start of 2014, the average yield of bonds in the S&P Municipal Bond Puerto Rico Index has improved by 0.11 percent to 7.33 percent. But the underlying prices of the bonds have plummeted; the index itself in 2013 fell 20.46 percent.

Since retail investors make up the bulk of municipal bond holders, this is a key development. When and if Puerto Rico is downgraded, much of the bad news should be priced into the bonds, and it will be time to look at buying.

“Events are still unfolding,” says Michael Comes, portfolio manager vice president of research at Cumberland Advisors’ Sarasota, Fla., office. “When things are still going downhill, it’s not a good time” to look at buying the debt.

Not all PR muni bonds are equal, he adds, noting that some bond issues, such as those backed by the commonwealth sales tax, are still rated investment grade.

Other PR issues currently yield 8 percent, and trade at around 70 to 80 cents on the dollar. Since muni bonds are tax-free, a taxable bond would have to yield about 15 percent for a similar return, he estimates.

You can see why PR bonds are so interesting. Still, there will be a ton of investors selling on any downgrade. Just on Friday, the S&P Dow Jones Indices removed bonds issued by Puerto Rico and other territories from the S&P National AMT-Free Municipal Bond Index. “It’s symbolic,” Comes says, “and could create more selling pressure.”

Keep your eye on Puerto Rico.

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