Puerto Rico downgrade a buying opportunity for some investors

Some savvy bond traders are describing Puerto Rico’s credit downgrade as “blood in the water,” a saying that translates to a buying opportunity for the most aggressive investors.
Seeing bond-rating agency Standard & Poor’s downgrade Puerto Rico’s general-obligation bonds to junk status Tuesday might have rattled some casual investors, but the move was already “firmly planted in the psyche of the bond market,” according to Jim Colby, chief municipal strategist at Market Vectors ETFs.
“The market was certainly expecting the downgrade because the warning was sent out several months ago,” he added.
Those closest to the muni bond market are now expecting Fitch and Moody’s to follow suit with similar downgrades.
With Puerto Rico’s 10-year general-obligation bond now yielding 9.5%, some corners of the muni bond market are starting to take advantage of the panicked selling.
“Depending on your view of the credit, and mine is pretty positive, it’s probably a time to add some key positions in Puerto Rico,” said Roberto Roffo, senior vice president and portfolio manager at Advisors Asset Management.
“Right now, there’s blood in the water and there’s a lot of irrational fear in the bond market,” he added. “Over the long run, you’re going to make a lot of money if you pick and choose the right bonds.”
For some perspective on Puerto Rico’s municipal bond yields, an equivalent yield from a sovereign 10-year taxable bond would need to be 14.4%. The 10-year U.S. Treasury is currently yielding 2.67%.
Puerto Rico’s bond yield levels are really only news to those who have not been paying attention.
“The expectation was that the downgrade was going to happen because a lot of fundamental metrics related to employment and business growth were all in place showing that the government wasn’t going to be able to balance its budget,” Mr. Colby said. “The downgrade was almost a moment of relief, because now there’s no more waiting for it to happen.”
What has investors like Mr. Colby so comfortable with Puerto Rico’s debt is that the yields are currently higher than any other high-yield muni debt, and Puerto Rico’s debt was only downgraded to junk status one day ago.
“The yields are so high because it’s a bit of panic selling right now, and I think the bonds are vastly oversold,” he added. “You can understand the concern, but you can’t equate that with current valuations.”
Part of what has been driving yields higher since last summer is the fact that most of the bond market could see the story unfolding. With that in mind, a lot of institutional investors that are prohibited from holding below-investment-grade debt took some pre-emptive action by shedding the bonds ahead of the downgrades.
There are those, however, who feel the bad news is just beginning in Puerto Rico, and that the yields are high for good reason.
“We know there are more downgrades to come, but regardless of what the rating agencies say, the Puerto Rican economy continues to get weaker and the budget remains out of balance,” said Eric Friedland, portfolio manager and head of municipal research at Schroder’s Investment Management North America Inc.
“So far, the corrective measures that the government has taken have been self-defeating , including things like higher corporate income taxes that is forcing more corporate entities to leave the island,” he added. “It’s just not a credit profile that looks to be improving any time soon.”
The yields might be high, but the situation is beyond the comfort zone of Bruce Allen, owner of the advisory firm Bruce G. Allen Investments.
“The numbers look terrible to us and that’s one bullet I managed to dodge,” he said. “We’re in Colorado and we’ve sometimes looked at places like Puerto Rico for some muni bond diversification, but we’re just not comfortable with the level of debt they have right now.”