Blind focus on yield endangers muni market

SMART MONEY

In mid-March, the Commonwealth of Puerto Rico, the third largest borrower in the US municipal bond market, raised $3.5bn in debt, with a yield of 8.7 per cent. It was not as costly as some feared, especially coming just weeks after the rating agencies had downgraded the island, given its $72bn in debt and another $40bn in unfunded pension liabilities.

It was especially attractive, given that the new bonds were triple tax free, which means many investors would receive an effective 12 per cent return. "Investors struggling with a low yield and a low supply environment face the quintessential risk versus reward dilemma while evaluating Puerto Rico debt," noted Citi Research analysts. Indeed.

Many hedge funds and sophisticated individual investors have opted for greed rather than fear in recent months. Four months ago, one investor bought a big chunk of the commonwealth's debt, close to its lows, attracted by an effective 14 per cent yield back then. The latest offer was at least three times oversubscribed.

Does that then mean that investing in the debt both of Puerto Rico and other risky local governments is wise?

Certainly the fact that the deal got done at rates far below the double digit level some had predicted gives the troubled territory stability, liquidity and more time to get its fiscal act together. Investors especially like the fact that the latest debt offer is almost akin to a debtor in possession financing, giving them more protection than other creditors. They are the most senior creditors, and they have assurance that any disputes will be governed by New York law and heard in a New York court.

Meanwhile, the governor has vowed to get the deficit down over time. But to turn things around will be a challenge. Not unlike Detroit, the island has a huge competitiveness problem. It has underinvested in its infrastructure for years. Almost half of its residents are below the poverty line, making Mississippi, the poorest American state, look prosperous. Its electricity costs are far higher than anywhere in the US.

So the analysis for many investors relies more on politics and Fed policy than on Puerto Rico's economic circumstances, which remain dire. Some compare Puerto Rico to that serial defaulter Argentina - except that the island is worse off since it cannot devalue its currency, and its best and brightest can easily move to the mainland US. One Fed official says, only half joking, that Puerto Rico should apply to the IMF for a structural adjustment program.

"My experience tells me that a country whose population and employment are falling will eventually hit the wall since income growth may never catch up to rising debt service, even if the country slashes spending," Michael Cembalest of JPMorgan's private bank wrote to clients recently.

The case for the ailing island is based primarily, the optimists say, on the importance of the Hispanic vote to both Democrats and (belatedly) Republicans. "The President can't let Puerto Rico go bust," says this investor. "They are a protected people."

But potential investors should understand that many of those who hold Puerto Rican debt intend to hold it only for the short term. Their appetite, as Citi notes, is a function of their need for yield rather than their belief that the territory can avoid restructuring its debt at some point.

Indeed, virtually every decision investors take these days is driven by the need for yield - and high returns by definition in a rational world, mean lower quality and higher risk. As long as the Fed keeps its easy money policies, Puerto Rico will find robust demand for its bonds, just as the corporate targets of buyouts do, despite their deep junk status.

Few issuers are thinking though of what happens when the Fed decisively moves away from its easy money policies - or when jittery markets bring rates up without waiting for the Fed. At that unknown time in the future, two things will happen. Investors such as pension funds will begin to sell their riskier stuff and the quality of issuers will start to matter more.

Few are thinking ahead to that time, though. California, for example, remarkably just produced a budget surplus. But rather than dedicate a portion of its revenues to debt service and restructure its debt profile to take advantage of the low rates today, it seems likely that California will instead spend all its unexpectedly large tax receipts. (Thank you, Silicon Valley!) But then, the US Treasury isn't exactly a great role model. It has started issuing floating rate debt - which investors understandably crave - but which will prove costly to the issuer.

Today, nobody seems to have a rainy day frame of mind. But when rates move up, and investors attempt to turn paper profits into real ones, they may regret their sunny assumptions.

© The Financial Times Limited 2014. All rights reserved.
FT and Financial Times are trademarks of the Financial Times Ltd.
Not to be redistributed, copied or modified in any way.
Euro2day.gr is solely responsible for providing this translation and the Financial Times Limited does not accept any liability for the accuracy or quality of the translation