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CHRISTOPHER J. MIER, CFA Managing Director/Head of Analytical Services Division Chris Mier is the Chief Strategist and director of the firm’s Analytical Services Division (ASD). The ASD has five full-time professionals and is one of the largest analytics groups of any public finance investment... More
  • The Best Trade On Puerto Rico Paper May Have Already Been Done! 0 comments
    Oct 28, 2013 2:20 AM | about stocks: MUB, SMB, ITM, CMF, NYF, NUV, KTF, KSM, SUB, SHM

    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). That's an exercise in seeking, and finding, alpha!

    (click to enlarge)

    The episode highlights three points:

    1. Given the high degree of uncertainty regarding the outcome of the Puerto Rico saga, the best strategy is to get to an appropriate benchmark position (for your institution) and adjust portfolio exposure opportunistically to take advantage of the swings in sentiment that are bound to occur with the ebbs and flows of market news. Discipline is required since returning to the established benchmark position is essential!
    2. The unusual dynamics of municipal bonds--shorting bonds is verboten, the yield curve is driven by the tax-exempt feature of the bonds (and expectations regarding future exemption), there are over 1 million CUSIPs which make liquidity of the type taxable investors are familiar with unheard of, etc.--suggest that trading strategies based on taxable yield curve dynamics may be inapplicable or downright unwise.
    3. 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.

    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.

    With the Massachusetts Attorney General having succeeded in securing the interest of the SEC in investigating sales practices involving municipal products, the likelihood of more state attorneys general joining the fray, a number of legal firms seeking retail investors to file class action suits, and entropy in the events surrounding Puerto Rico increasing with greater spread, it may be time for investors to take advantage of the narrower spreads available since the October 10th announcement to reduce positions. For investors sweating out "over-sized" positions in Puerto Rico bonds; now may be a good opportunity!

    Disclosure: I am long NIO.

    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.Additional disclosure: 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. Opinions expressed herein are current opinions only as of the date indicated. Any historical price(s) or value(s) are also only as of the date indicated and as applicable from any source that may be noted. 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.

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