NEW YORK (MainStreet) — The severity of the Puerto Rican debt crisis has come to the surface over the past several weeks, with credit rating downgrades to junk status from S&P, Moody's and Fitch. Despite the blow to Puerto Rico's financial credibility, the country is now looking to raise upwards of $3 billion in debt during March.
Yields on Puerto Rican bonds are now hovering at a staggering level, reaching 10% in February, as investors demand greater yields to compensate for the added risk of Puerto Rico's debt.
Municipal bonds are attractive thanks to tax exemptions. Even Puerto Rican municipal bonds pay tax-free interest returns all 50 states.
Surprisingly, demand is high for this round of bonds Puerto Rico is set to issue, primarily from hedge funds, which is putting downward pressure on yields.
"One might expect yields of Puerto Rico general obligation bonds to rise in advance of a $3 billion bond issuing, but the opposite is happening," says J.R. Rieger, vice president of fixed income indices at S&P Dow Jones Indices.
The new issuance is expected to include additional general obligation bonds, considered safer, since the government has authority to raise taxes in an effort to pay general obligation bondholders, should the country face trouble in making investors whole.
Puerto Rico's issues largely stem from high unemployment, infrastructure issues, unfunded pensions and difficulty in collecting taxes, Rieger says. This combination created the perfect storm for a debt crisis and subsequently, multiple credit rating downgrades.
"The world has known Puerto Rico has fiscal challenges and the market reacted more to those challenges now than in the past," Rieger adds. "It has been a very strong negative reaction since the summer of 2013."
Retail investors are exposed to Puerto Rican bonds largely through bond funds invested in Puerto Rican debt. These funds now face additional risk, causing investors looking for safe and steady returns in a low-interest rate environment to be uncomfortable with the new level of risk.
To illustrate the increase in risk, consider standard, plain vanilla municipal bonds, from cities and states across the country. "These bonds are yielding lower than Puerto Rico, which is a sign that there is higher risk in Puerto Rico," Rieger adds.
The S&P National AMT-Free Municipal Bond Index, which is a broad measure of performance in the United States municipal bond market, yields 2.5%. This is significantly lower than the S&P Municipal Bond Puerto Rico General Obligation Index, which yields 7.5%, an increase of 3.5 percentage points year-over-year.
"The proof will be in the pudding on whether they can sell $3.5 billion worth of bonds, which is a lot for this market to absorb," Rieger says. "Big institutions are looking at Puerto Rico because there is little interest from other investors."
- Written by Scott Gamm for MainStreet. Gamm is author of MORE MONEY, PLEASE