Looking For High Yields? Buy Puerto Rico Bonds

by: Lovet A. Ako

Puerto Rican bonds yield between 9% and 12%.

These are distressed, risky bonds recently downgraded by Moody's.

Puerto Rico's government is taking steps to turn around economy.

Moody's may not like Puerto Rican bonds, but I do. And if you're looking for high yield bonds, you should like these too.

In an environment where high-yield corporate bonds are paying less than 5%, short-term Puerto Rico bonds are yielding around 9%. Further out on the curve the yield gets as high as 12%.

Do I have your attention now?

There's no doubt Puerto Rican bonds are risky. All distressed bonds are risky if you don't know what you're doing. But, if you want really high yields you need to take on some risk.

Two weeks ago, Moody's Investors Service downgraded $54.8 billion of Puerto Rico's $73 billion of debt, deep, deep, deep into junk bond territory. The ratings service cut the Commonwealth of Puerto Rico's general obligation and guaranteed bonds to Caa2 from Caa1.

It cut the Government Development Bank for Puerto Rico's notes three notches, from Caa1, to the second-lowest possible credit rating, Ca. Moody's said the GDB may run out of cash in August. The GDB acts as the island's central bank and finance ministry. Most other credits were cut by two notches. The outlook for all affected securities remains negative.

People holding these bonds may be ready to throw in the towel and sell, but I'm telling you to stay the course. I own Puerto Rico and I'm buying more.

These general obligations are municipal bonds issued by the Commonwealth of Puerto Rico, which means they are tax-exempt. In fact, they're triple tax-exempt. No federal, state or local taxes are incurred. The bonds are used to pay for infrastructure, such as sewers, electrical plants and highways.

There's no question that this U.S. territory is having an economic crisis. Every year since 2006, the island's economy has shrunk. In addition, there are 7% fewer people to help repay the obligations.

But, the government has finally taken steps to turn things around.

On the heels of the downgrade, Governor Alejandro Garcia Padilla presented the budget for the next fiscal year. It has $674 million of spending cuts and closes almost 100 schools and 20 public agencies. The island's House of Representatives voted to raise the sales tax to 11.5% from 7%. The bill also creates a new 4% tax on professional services.

If the Senate approves the measure the sales tax increase goes into effect July 1 and the professional services tax would begin Oct. 1. Next April, the sales tax would change into an 11.5% value-added tax.

"The proposed tax increases could generate $1.2 billion in revenue, which economist Gustavo Velez said would help boost the government's liquidity and strengthen the island's Government Development Bank so it can issue up to $2.95 billion in bonds as planned," according to the Associated Press.

Not all general obligation bonds are insured. So the way to buy these bonds is to only buy bonds insured by the big bond insurers, MBIA (MBIA) and Assured Guaranty (NYSE:AGO).

If the bonds default, but you have insurance, the insurance companies guarantee to pay the coupon till they mature and the full principle at maturity.

In November, 2014, Moody's said both MBIA and Assured Guaranty "will be able to absorb possible losses on the electric authority, PREPA, bonds they insure without significant pressure on their credit profiles."

The best way to find out if the insurance companies can pay the claims is to look at the rating of the insurer's corporate bonds. Assured Guaranty has a rating of A3, which is investment grade with low credit risk. The senior debt rating of MBIA is Ba1, which is the highest junk bond rating, or one below investment grade.

This investment works for someone who has a stomach for volatility. You might be able to buy at 70 cents to the dollar and sell for 90 cents, but you should be willing to hold the bonds to maturity. For if they do default that's when you will get the principle back.

I'm buying Government Development Bank notes, Puerto Rico's general obligation and guaranteed bonds and Sales Tax Financing Corporation (or COFINA) bonds with maturities between 2024 and 2040.

Here is a sample. Obviously, these bonds are trading at a severe discount. All prices are as of May 25.

The benchmark Puerto Rico Commonwealth Series A bonds maturing in 2035 have an 8% coupon. On May 25, they traded at $83.75 with a yield to maturity of 9.874%

The Puerto Rico Commonwealth Highway and Refunding Teodoro Moscoso Bridge-A bond matures in 2018 and has a 5.55% coupon. It trades at $83.875 with 11.805% yield to maturity.

The Puerto Rico Electric Power Authority Power Series EEE-Build America BDS, which matures in 2030, has a 5.95% coupon. It's priced at $57.625 and yields 12.09% to maturity.

Disclosure: The author is long GOVERNMENT DEVELOPMENT BANK NOTES, PUERTO RICO'S GENERAL OBLIGATION AND GUARANTEED BONDS AND SALES TAX FINANCING CORPORATION (OR COFINA) BONDS WITH MATURITIES BETWEEN 2024 AND 2040. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.