Headlines have been swirling around the recent sell-off in Puerto Rico uninsured bonds after comments made last Sunday by Puerto Rico Governor Alejandro Garcia Padilla about the serviceability of the Commonwealth’s debts. In an interview with the New York Times, published June 28th, Garcia Padilla stated that the debt “is not payable” and “There is no other option…. This is not politics, this is math,” referring to concessions he will be seeking from creditors over the coming days, weeks, and months as part of a possible financial restructuring.
The Governor’s about-face comes as a surprise to investors since it is a major shift in tone from his prior statements assuring investors of Puerto Rico’s intent to service its obligations in full and on time.
Uninsured Puerto Rico bonds have seen significant downward pressure off of the Governor’s statements. General-obligation and sales-tax bonds are trading down 5%-10% from Friday levels. Puerto Rico’s bellwether 8% general-obligation bonds due in 2035, of which there are $3.5 billion outstanding, have reached new lows, trading to as little as 68.50 cents on the dollar, to yield 12.25%. The sell-off in the marketplace remains confined to uninsured bonds. We do not purchase uninsured bonds.
In contrast, the insured space has retained a level of stability, although there haven’t been many trades of size. The offered side has seen only a slight cheapening, with AGM-insured debt trading near 5.25% and MBIA-insured bonds slightly cheaper. Smaller-sized trades offer opportunities to purchase bonds at yields closer to 6.5%.
Interestingly, the remainder of the municipal bond market has been immune to this weakness, trading lower in yield following movements in US Treasuries.
We reiterate our stance that Puerto Rico insured debt is money-good and offers relative value versus most other asset class alternatives. Where else can AA-rated debt be purchased at yields approaching 10% on a taxable-equivalent basis? The truth is that investors who have performed due diligence on the bond insurers and can stomach some volatility are being rewarded with what we consider to be a “retail investor Puerto Rico fatigue and headline risk premium.”
We will walk through the economics of bond insurance on Puerto Rico debt.
MBIA's (NYSE:MBI) and Assured's (NYSE:AGO) total claims-paying resources are in the multiple billions and the companies have operating income in the hundreds of millions. Even assuming a drastic 50% haircut on principal and interest coming due in the next few years, these losses are easily absorbed into operating income without dipping into capital. Insurers only insure investment-grade credits to a “zero-loss standard.” Other public finance portfolio exposures are likely to have default experience consistent with the remainder of the investment-grade market average over the past 40 years of 2.87%. If we look at default experience prior to the Detroit and Jefferson County bankruptcies, the number shrinks to 0.08%.
Troubles in Puerto Rico highlight the value-add of bond insurance. Puerto Rico, Detroit, and other “headline risk events” may be the best things ever to occur to spur the revival of the bond insurance industry. Wider credit spreads will increase demand for insurance product and, by extension, the operating income out of which bondholders are repaid. Bondholders have several arrows in their quiver, including the ability to benefit from negotiating leverage afforded by insurers’ large exposure to the Commonwealth. We will keep readers apprised of future developments