Is the Potential for Tax-Exempt Yield Really Worth the Risk?June 22, 2016
In a recent period of low stock market returns, low interest rates and low economic growth, investors have faced the temptation of trying to find the elusive outperforming investment. Who wouldn’t want to speed into the investment performance fast lane while others are stuck in traffic? Recently, promised outperformance has come from hedge funds, limited partnerships and high-yield bonds. Yet, as history proves again and again, great expected returns also mean taking on great risk. This year, the latest exemplar of this was the municipal bond market.
Would you buy a bond backed simply by the good faith of an entity that was drowning in debt and had poor growth prospects? What if the debt to GDP ratio rose above 70% as revenue dried up and borrowing cost rose?1 And what if this entity did not have the option of defaulting on its debt? Yes, the investment we’re discussing is Puerto Rico Municipal Bonds.
Why would anyone want these? Three words: triple tax exemption. The interest on these bonds is exempt from U.S. federal, state and local taxes! Many investors found the large tax-equivalent yields too great to pass up.
We initially discussed this topic in our quarterly review last summer following what Puerto Rico Governor Alejandro Garcia Padilla described as a “death spiral.”2 But the topic has come up once again with recent references on This Week Tonight with Jon Oliver and American Public Media’s Marketplace.
This debt crisis has been brewing for some time, yet seemingly investors believed the risks were not substantial. As recently as 2005, the rating agency Standard and Poor’s rated Puerto Rico debt as A-; however, by 2007 it was BBB-, the lowest possible grade within the Investment Grade universe.3 In 2014 it fell to BB, going to High Yield or Junk Bond status for the first time. As of late 2015, their current rating was CC with a negative outlook.
It came as a big surprise to many investors to find that their otherwise innocuous sounding fixed income investments were actually holding significant portions of Puerto Rico debt. The declines seen over the last year have been noteworthy, especially for many conservative investors who did not look into what risk exposure they were actually getting.
For investors who want higher-credit-quality bonds, Puerto Rico has not been an option for some time now, due to the cratering of its credit rating.
Investors trying to stretch for that extra bit of yield should be aware of the risks they’re taking to do so. In the case of Puerto Rico debt, the gleam of triple tax exemption may have blinded many to the real risks they were taking on.
As always, if something sounds too good to be true, it probably is not a good investment.
All investments involve risk, including the loss of principal and cannot be guaranteed against loss by a bank, custodian, or any other financial institution. Fixed income investments are subject to interest rate and credit risk. Emerging markets involve additional risks, including, but not limited to, currency fluctuation, political instability, foreign taxes, and different methods of accounting and financial reporting. Real estate securities funds are subject to changes in economic conditions, credit risk and interest rate fluctuations.
1“Puerto Rico’s Debt Crisis Is About to Get Worse,” Amilcar Antonio Barreto, Fortune, May 10, 2016
22015 Q2 QIR: https://www.youtube.com/watch?v=Gk6qLgasRmE&list=PLvIzCGfnTtn6yqJgr_mUe4FZoR6A_drYF&index=3
3Commonwealth of Puerto Rico, Standard & Poor’s Historical Ratings, Sept. 2015 | “Puerto Rico’s ‘death spiral’ can be traced back to one mistake,” Linette Lopez, Business Insider, Aug. 7, 2015 | “Puerto Rico’s Governor Says Island’s Debts Are ‘Not Payable,’” Michael Corkery and Mary Williams Walsh, The New York Times, June 28, 2015
Sign up to get email updates with our latest blog posts