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Muni Bond Talk

Dump Puerto Rico Municipal Bonds? Nah

Rumors about Puerto Rico’s financial problems surface as often as the seasons change. We have been hearing the sky is falling about Puerto Rico for years now. Some say if Puerto Rico was a state of the United States, they would rank 51st (dead last) when comparing the size of their debt to their Gross Domestic Product. It would be the only state rated below A by the three major credit rating agencies. Although the credit rating agencies have their own credability problems.

The fact is there is still enormous demand for Puerto Rico Bonds and with yields hovering around 4% for 10 year maturity dates, these bonds are very cheap compared to other states. The income from Puerto Rico bonds, and by the way most other US territories, is triple tax free regardless of what state you reside. While a New Yorker might have to pay state and city income taxes on a municipal bond issued in California, they do not on Puerto Rican debt. Plus investors get improved diversification if they own too many single state bonds.

Like most states, the constitution of Puerto Rico requires that debt holders be paid before any other expenditures. In theory, bondholders get precedence over paying government workers and pensioners.

Some say the Federal government would step in to make payments, if the Puerto Rico could not. However, when major municipal governments faced loan defaults in the past like the New York City when federal government said Drop Dead to NY’s request.

So what is the risk of owning Puerto Rico bonds? Here is what the naysayers claim…

Puerto Rico is running a budget deficit (the difference between revenues and expenditures) and has amassed about $50 billion in debt and forward obligations (pension liabilities). This is over 100% of the state’s Gross National Product (GNP). This is over 5 times the amount of most states. If every dollar of state government revenue went to repaying debt, and the state did have any expenses, it would take over 8 years to repay the debt, and that doesn’t even include interest costs.

The economy of Puerto Rico is hurting. They are not on path to eliminate the budget deficit which will continue to add to their debt burdon.
Puerto Rico is completely dependent on the continued willingness of investors to lend it more and more money every year. At some point, the appetite of investors will turn away from their bonds, which become increasingly more risky every year as their debt load increases. Until then, investors will enjoy after tax yields that are over twice as much as other Municipal bonds.

More to come on the risks of owning Puerto Rico bonds.

3 Responses to “Dump Puerto Rico Municipal Bonds? Nah”

  1. David Waring says:

    There are a lot of good reasons not to hold this debt. In addition to what is listed in the article:

    - Their debt-to-GDP ratio is now 90%, compared to 57% in 2001.

    - For the reasons you mention above most of their debt is not owned by locals. Because of this there will not be pressure from the local population not to default.

    - Pensions are only 14% funded.

  2. Asri says:

    I’ve done some muni investing. A few tutghhos:1)Munis are generally exempt from federal income taxes and from taxes in the state that issued them; however, certain bonds (“AMT bonds”) have their income counted for alternative minimum tax purposes. Depending on an individual’s personal tax situation, this may or may not be a problem.2)Like most bonds, munis are to some extent a bet on the direction of interest rates. If you buy a 10-year bond paying 4% and interest rates rise sharply, then you can either hold the bond (meaning you will be getting less than you would have if you had waited to buy it) or (all other things being the same) sell it for less than you paid for it. If interest rates fall, though, you will be able to sell the bond for more than you paid for it.3)I’ve never watched Suze Orman, but understand she has a lot of her own $ in zero-coupon munis, which don’t pay interest over time but accumulate it and pay it at the end. These are especially interest-rate-sensitive, and IMNSHO probably not a good idea for the average investor to use as a major part of his/her portfolio.4)If there is a big income tax increase, munis will become more valuable and the interest rates they pay will decline accordingly.

  3. QCK01 says:

    If you buy a 10-year bond paying 4% and interest rates rise sharply, then you can either hold the bond (meaning you will be getting less than you would have if you had waited to buy it) or (all other things being the same) sell it for less than you paid for it.

    Asri,

    This is not true! Regardless of where interest rates go, you will receive the same coupon payments. So, if you buy a bond with a 5% coupon it will pay the same amount if interest rates is 2% or 4%. What will be affected is the value of your investment. For example, if you buy $50,000 face value of a bond in a rising interest rate evironment as rates move up your $50,000 may be worth $49,500 or vice versa in a declining interest rate environment. This shouldn’t be a concern because you buy bonds for income and protection of principal. Regardless of what rates do, when you buy quality bonds you will receive par for your bonds at the call or maturity date.

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