Tuesday, October 8, 2013

Puerto Rico Bonds for Equity Investors?

Every once in a while an opportunity arises in the fixed income market that offers an interesting alternative to equity investors.  While they are usually high risk, the potential gains can also be intriguing.

Let me say again at the onset of this post that this is a very risky situation, and I am emphatically telling readers that this should not in any way be considered a recommendation to buy bonds.

The bonds issued by various entities in Puerto Rico have been under pressure in the last few months for several reasons.

Here's an excerpt from a recent Reuters article on the situation:

The steep decline in prices of Puerto Rican bonds on the American municipal bond market is taking a heavy toll at home, where local institutions and individuals own an estimated 30 percent of the $70 billion of outstanding bonds.

Heightening worries in recent months about Puerto Rico's shrinking economy, double-digit jobless rate and per capita debts far higher than in any U.S. state touched off a wave of selling and briefly pushed some Puerto Rico yields to over 10 percent.

The yield on Puerto Rico's general obligation 30-year bond hit a recent peak of 8.58 percent, up from 5.49 percent on June 30. The steep drop in prices, which move inversely to yields, has hit local banks and closed-end and mutual funds marketed to bond buyers in Puerto Rico. Some of the Caribbean island's bonds fell to as low as 60 cents on the dollar.


The problems in Puerto Rico are real:  the economy is scheduled to shrink by -5% in 2013, and the commonwealth has been essentially cut out of the public debt markets.  Instead, it has turned to the banks, who are carrying most of new lending burden but at very onerous rates.

However, here's the interesting part:  while the major rating agencies are obviously concerned, the rating of the general obligations of Puerto Rico remain investment grade.  Moreover, Puerto Rico bonds backed by a senior lien on sales taxes are still rated AA- by S&P.

So why are the prices of Puerto Rican bonds plummeting?

Much of the recent decline appears to be related to leveraged bond fund selling.  According to Forbes, brokerage firm UBS aggressively marketed leveraged bond funds investing in Puerto Rican debt over the past few years.  When prices started falling, investors and funds were forced to sell, regardless of price, which has exacerbated an already precarious credit situation.

Here's an excerpt from a recent column:

Over the past decade, UBS has sold roughly $10 billion of Puerto Rican debt, much of it packaged in its own proprietary closed-end funds. One series of such closed-ends is entitled the “Puerto Rican Fixed Income Funds.” Over the summer and into the fall, these closed-end UBS funds have cratered in value as the Puerto Rican economy has sunk in recent months...

“The bank’s clients had piled into highly leveraged bond funds run by UBS and were encouraged by its brokers to borrow even more money to invest in those funds,” Craig reported. “In some cases, money was lent improperly, exacerbating current losses, according to UBS employees in the region.”

She continued: “Now, a number of UBS clients have been forced to liquidate hundreds of millions of dollars in holdings in these funds to meet margin calls. And the bank says it has begun an internal investigation into the lending practices of some of its top-producing brokers.”


 Not only were the funds levered - many clients borrowed money to buy the funds, which dramatically increased the risk.  Here's the New York Times last week:

..many clients took out margin loans to buy into the funds. Other investors, according to local brokers and a lawyer representing some UBS clients who are considering suing the bank, were encouraged by their brokers to borrow on credit lines, which customers typically use to buy items like second homes or even to expand their businesses.

Most banks require investors who are given a credit line to sign a document saying they will not use it to buy securities. Instead, investors use margin loans, which are specifically governed by regulators and allow banks to more closely monitor what sort of risks their clients are taking on.

“When you add leverage on top of leverage, and then add more leverage, it usually doesn’t end well,” said Thomas R. Ajamie, a lawyer who frequently represents investors in financial cases.


So in my equity-trained mind, what we are seeing here is massive selling pressures, pushing prices lower, which in turn adds to the economic pressures.
But when the selling ends, at some point the bonds might be a buying opportunity.

Why do I say this?

I am not an expert on Puerto Rico, but I know that any entity that has $70 billion in bonds outstanding needs continued access to the credit markets.  While there may be a strong desire to force losses on bond holders, once a borrower stiffs its creditors it is not likely to have a welcoming reception in the future.

Moreover, while Puerto Rico is obviously not a state, it seems hard to believe that the U.S. government would let one of its protectorates go belly up.

Unfortunately, at this writing, I am not alone in my look at Puerto Rican bonds.  According to our fixed income folks, even long maturity PR bonds are trading at "only " an 8% yield - nice, to be sure, but not yet at the point where they are competitive to equities in my opinion.

But if we see more year-end selling, the situation might change.