The Best Trade On Puerto Rico May Have Already Been Done!

Includes: ITM, MUB, PZT, RVNU, TFI
by: Chris Mier

While John Dizard counsels investors in his Financial Times opinion piece from October 18 ("Puerto Rican Muni Bonds - a new production of 'West Side Story'") to wait for telltale yield curve signals before making a play on Puerto Rico debt, he has already unwittingly failed to "outsmart {the} admittedly slow professional muni bond investors" that he references. Why? Because the best trade may have already been done!

Spreads in the summer of 2012 were very tight on Puerto Rico paper relative to those currently prevailing. Credit concerns regarding Puerto Rico are nothing new for muni investors and have weighed on the muni market for many, many years. investors following an investment strategy driven primarily by credit calls, rather than yield curve or market signals, had ample opportunity to sell Puerto Rico exposure last summer before reloading in September and October of 2013 after spreads on general obligation bonds had widened to between 350 and 400 basis points over the widely used benchmark AAA MMD scale.

Puerto Rico paper has rallied dramatically in the wake of an announcement on October 10th of a planned Investor Webcast (held on October 15th) by the Government Development Bank (GDB). Spreads to MMD, as shown by the frequently traded Puerto Rico General Obligation 5% coupon bonds of 2041, have narrowed a full 100 basis points in two weeks! Now the trade can be reversed to capture the excess performance and return to a more modest benchmark exposure (if any is desired). That's an exercise in seeking, and finding, alpha!

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The episode highlights several important points. First, while Mr. Dizard waits for a yield curve signal that may never happen to initiate his first trade, the credit-oriented muni bond investor could have dropped a lot of alpha into their clients' portfolios using a conservative strategy relying on what they know best--the appraisal of credit quality.

Secondly, a wide array of event risks have increased the influence of factors unrelated to credit fundamentals with respect to Puerto Rico bond valuations. The outcome of these factors is difficult to predict and the impact on the market value of the bonds is uncertain. Some of these factors include the Massachusetts Attorney General's investigation into the sales practices regarding Massachusetts muni bond mutual funds containing Puerto Rico paper. The SEC has now initiated their own similar investigation. A growing number of law firms are soliciting interest from individual investors in joining class action suits against brokerage firms, mutual fund companies and other financial services firms that have sold products with Puerto Rico exposure in order to recoup lost market value.

The unusual dynamics of municipal bonds--shorting bonds is verboten, the yield curve is driven by the value of the tax-exemption and expectations about future tax policy, the market has over 1 million CUSIPs which make liquidity of the type taxable investors take for granted unheard of, among others--suggest that trading strategies based on taxable yield curve dynamics may be inapplicable or downright unwise.

Finally, the GDB's Investor Webcast may have delivered more excitement than information, giving the astute investor a clear opportunity to take advantage of the unwarranted market emotion that has driven spreads sharply narrower in the aftermath of the Webcast.

Given the high degree of uncertainty regarding the outcome of the Puerto Rico saga, investors may want to reduce positions now that spreads have narrowed. There may be trading opportunities to take advantage of the swings in sentiment that are bound to occur with the ebbs and flows of market news down the road.

Disclosure: I am long NIO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: In addition, I have two municipal mutual fund positions--a high yield municipal bond fund and a tax-exempt money market municipal fund--both of which may own Puerto Rico paper. I have no individual Puerto Rico bonds. Loop Capital Markets LLC, an investment bank, prepared this document for informational purposes only. Loop Capital Markets LLC does not provide research services, therefore this product is not a research report and it should not be construed as such. Loop Capital has or may have provided investment banking services to issuers referenced in this document. All materials are indicative and for discussion purposes only. Opinions expressed are our present opinions only and are subject to change without further notice. The information contained herein has been prepared solely for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or instrument or to participate in any trading strategy. Loop Capital Markets LLC shall have no liability, contingent or otherwise, to the user or to third parties, or any responsibility whatsoever, for the correctness, quality, accuracy, timeliness, pricing, reliability, performance or completeness of the data or formulae provided herein or for any other aspect of the performance of the materials. Loop Capital Markets LLC is a Delaware limited liability company.