Since our last update on the Commonwealth of Puerto Rico, events have been unfolding rapidly. On Friday, the Senate in Puerto Rico approved a $3.5 billion bond issue. The Bond Buyer highlighted events in Puerto Rico in its weekly review. Hedge funds, the likely potential buyers of the new bond issue(s), are demanding that governing law change from Puerto Rico to New York. Speculators are beginning to sense a rally in Puerto Rico bonds in the near future.
In this analysis, we update the current market view of two key Puerto Rico bond issuing entities and show how that view has evolved since June 1, 2013, with a particular focus on trades since February 17, 2014. We note that the credit default swaps of Puerto Rico have never traded according to the data provided by the Depository Trust & Clearing Corporation, so the bond market is the dominant source of information on the market's view.
Conclusion: We find that the rally in Puerto Rico general obligation bonds is already well underway, with credit spreads off more than 2.00% from their peak. The rally in Puerto Rico Sales Tax Financing Corporation bonds has been much more modest. Those bonds only trade at credit spreads about 1.00% below those on general obligation bonds.
Analysis of Puerto Rico Bond Issues
We re-analyze all of the trades from June 1, 2013 through March 3, 2014 on two Puerto Rico-affiliated bonds: the 5.75% bonds due July 1, 2041 and issued by the Commonwealth of Puerto Rico (Public Improvement Bonds of 2011-General Obligation Bonds (PR), CUSIP 74514LYW1) and the 5.25% bonds due August 1, 2040 issued by the Puerto Rico Sales Tax Financing Corporation (Sales Tax Revenue Bonds, Senior Series 2011C, Current Interest Bonds (PR), CUSIP 74529JNX9). The terms of the bonds are summarized in an appendix below.
Puerto Rico Municipal Bond Issue Yields and Credit Spreads
The MSRB website EMMA includes recent trading activity on a vast array of municipal bond issues in the United States. We use that data to derive the credit spreads of the 5.75% bonds due 2041 issued by the Commonwealth of Puerto Rico and the 5.25% bonds due 2040 issued by the Puerto Rico Sales Tax Financing Corporation. From June 1, 2013 through March 3, there were trades for a total principal value of $406.7 million of the 5.75% Commonwealth bonds due 2041. This is more than 130% of the total principal amount of these bonds. The average trading volume per day during this period was $2.3 million, with a high of $81.8 million per day and a low of $0. We remind the reader that there were zero transactions in the credit default swaps of Puerto Rico during the same period (source: Depository Trust & Clearing Corporation and a recent analysis by Kamakura Corporation).
For the 5.25% bonds due 2040 issued by the Puerto Rico Sales Tax Financing Corporation, there were trades for a total principal value of $635.6 million. This is more than double the principal amount of the bonds outstanding. The average trading volume was $3.6 million per day, with a high of $97.3 million and a low of $0. Between the two bond issues, trading averaged $5.9 million per day and the total trading volume over all days was $1,042 million.
Although it is often argued that trading in Puerto Rico bond issues is dominated by hedge funds, this histogram of trade sizes since June 1, 2013 shows that 95% of trades (by trade count) are for $1 million or less in the Commonwealth of Puerto Rico 5.75% bonds. Note that the right hand bar is for trades of $3 million or more.
A similar distribution is seen for trades in the Puerto Rico Sales Tax Financing Corporation 5.25% bonds due 2040, according to the MSRB. Note that the right hand side bar is for volumes of $5 million or more per trade.
For the trades for which MSRB reports an explicit dollar trade amount on either of the two Puerto Rico bonds studied, there were 19 trades of $10 million or more during the June 1, 2013 to March 3, 2014 period. The most recent of these trades was October 30, 2013.
Calculation of Credit Spreads
On each day for which a trade was reported, the yields to maturity for each trade were collected from the MSRB website. The remaining maturity of the bonds was calculated and the matched maturity U.S. Treasury yield was calculated using Treasury rate information from Kamakura Risk Information Services and the U.S. Department of the Treasury. The credit spread was calculated simply as the bond yields minus the matched maturity U.S. Treasury yields. Because of the current trading levels on the bonds, we ignore the impact of early redemption in what follows. We turn now to those results.
Commonwealth of Puerto Rico Public Improvement Bonds of 2011
The evolution of yields to maturity and matched maturity Treasury yields on the 5.75% general obligation bonds due 2041 is shown in this graph. The cluster of dots on the right hand side of the graph reflects both an increase in the number and volatility of trades:
All trades during this period are reflected on this graph with no omissions or smoothing. For the readers' convenience, we have added a smooth line to the reported yields on the 5.75% bonds due 2041. Obviously, the spreads versus matched maturity Treasuries have climbed steadily at first, fallen briefly in late October and early November, and then resumed climbing through the end of December. Since January, however, credit spreads have fallen steadily as shown in the following graph:
A daily summary of credit spreads and trading volume is shown below for both the 5.75% general obligation bonds due 2041 and the 5.25% Sales Tax Revenue Bonds due 2040. The credit spreads on the 5.75% bonds have declined almost 200 basis points from their peak and the differential versus the 5.25% bonds is close to 1.00%.
Puerto Rico Sales Tax Financing Corporation Sales Tax Revenue Bonds
Senior Series 2011C Current Interest Bonds (PR)
The yield to maturity on the 5.25% bonds due 2040 is shown versus U.S. Treasuries in this graph through March 3, 2014:
Credit spreads on the same bonds are plotted here, where one can see the same trading activity increase and volatility that we mentioned above. The decline in spreads, however, is fairly small.
The daily summary given above shows that on the relatively high volume trading day (February 20), credit spreads on the 5.25% bonds due 2040 moved to 3.20%.
Comparing Credit Spreads for the Commonwealth of Puerto Rico General Obligation Bonds and the Puerto Rico Sales Tax Financing Corporation Senior Series 2011C Bonds
If we plot the credit spreads on the two bonds jointly, the results show a dramatic difference in the perceived credit risk of the two entities:
Over the full June 1 to March 3 period, the Commonwealth general obligation bonds have traded at a premium to the credit spreads on the Puerto Rico Sales Tax Financing Corporation that has narrowed dramatically in the last few weeks. On the high volume trading days summarized above, the spreads between the two issues have moved much closer to 1.00%, a very significant decline.
The rally in Puerto Rico general obligation bonds is already well underway, with credit spreads off more than 2.00% from their peak. The rally in Puerto Rico Sales Tax Financing Corporation bonds has been much more modest. Those bonds only trade at credit spreads about 1.00% below those on general obligation bonds.
Background on the Bonds Analyzed
The analysis above is focused on two Puerto Rico-affiliated bonds. The first bond, issued by the Commonwealth of Puerto Rico, was issued on these terms:
The original issue documentation and current financial information is available from the EMMA website of the Municipal Securities Rulemaking Board ("MSRB").
The early redemption provisions on the bonds are described in this paragraph:
Although some of the bonds issued by the Commonwealth on the same date (July 12, 2011) were insured, the 5.75% bonds due July 1, 2041 are not covered by that insurance.
The second bond was issued by the Puerto Rico Sales Tax Financing Corporation on these terms:
The documentation for this bond issue is also available at the EMMA website of the MSRB.
The seniority of the bonds is described as follows:
The 5.25% bonds due August 1, 2040 are subject to early redemption as described in this paragraph:
Regular readers of these notes are aware that we generally do not list the major news headlines relevant to the organization in question. We believe that other authors on Seeking Alpha, Yahoo, at The New York Times, The Financial Times, and the Wall Street Journal do a fine job of this. Our omission of those headlines is intentional. Similarly, to argue that a specific news event is more important than all other news events in the outlook for the organization is something we again believe is inappropriate for this author. Our focus is on current bond prices, credit spreads, and default probabilities, key statistics that we feel are critical for both fixed income and equity investors.
Additional disclosure: Kamakura Corporation has business relationships with a number of organizations mentioned in the article.