Week of 8/12/2019

High Yield Munis Rally… A Bull Market For Munis… Economy Faces Higher Risks… Puerto Rico Revenues Beat Estimates By $1 Billion… Federal Monitor Of PR Disaster Aid… PREPA Auditor Under Investigation… Bond Insurer Sues Puerto Rico Bond Underwriters… Puerto Rico Bonds Rally Amid Governance Turmoil…

High Yield Munis Rally…Fading yield prospects fuel high returns on high yield muni bonds. Non-investment grade tax-free bond index has returned 8.7% this year; the longest maturities have logged over 10% return. The 10-year U.S. Treasury yield, 1.69%, has chances of dropping below 1% within a year, Bank of America Merrill Lynch estimates. Comparable German and Japanese bonds offer far less with negative yields. Negative U.S. Treasury yields cannot be ruled out per PIMCO. Investors are faced with fewer opportunities to earn a yield on investments.

A Bull Market For Munis…An outlook for lower yields has led investors to increase their pace of buying tax-free bonds. The largest weekly purchases of muni bonds came last week with $2.35 billion of new inflows. For 31 straight weeks, investors have poured money into the muni market. Plenty of demand was found for $13.2 billion tax-free bonds issued last week. The week brought strong gains for tax-free bond investors. Tax-free investors are enjoying the price gains as bond yields have fallen. An index of tax-free bonds has returned 7% this year. Top-rated 30-year tax-free bonds yield 2.13%, the lowest since 2016 reflecting bond price gains. Bank of America analysts anticipate that the bull market for municipal bonds could continue until May 2020 or later. Lower U.S. Treasury yields could drive down yields of longest dated tax-free bonds.

Economy Faces Higher Risks…“You could take the view that the risks now had gone up,” and with an increased chance of a shock that could eventually prompt the Fed to return rates to near zero, “that would also call for more accommodation,” Chicago Fed President Charles Evans stated. St. Louis Fed President James Bullard and San Francisco Fed President Mary Daly have reiterated headwinds against the economy. Expectations of a recession in the next 12 months have grown since last month. A majority of economists expect the Fed to cut rates again in September. “Bond King” Jeffrey Gundlach estimates a three in four chance of a U.S. recession in 2020.

Puerto Rico Revenues Beat Estimates By $1 Billion…Puerto Rico’s General Fund revenue exceeded Fiscal 2019 forecasts by $1 billion. The outperformance reflects higher economic activity and improved tax enforcement. The Island’s cash coffers have grown steadily to $14.7 billion cash in various government bank accounts. Despite government corruption, the Island’s revenues have outpaced budgets for three years in a row. Eventual distribution of $49 billion promised Federal disaster aid carries a favorable prognosis for Puerto Rico’s General Fund revenue.

Federal Monitor Of Puerto Rico Disaster Aid…It is opportune that majority of the promised federal aid was kept away from the allegedly corrupt Rosselló administration. In the wake of Puerto Rico’s governance debacle, HUD will appoint a Federal Monitor tooversee $20 billion promised to Puerto Rico for community development. HUD has only released $1.5 billion so far. FEMA has already taken control of fund distribution and the U.S. Dept of Education ordered the Island to hire a fiduciary agent or trustee to oversee Federal Funds. More stringent oversight of Federal disaster aid funds favors Islanders and bondholders.

Puerto Rico Electric Power Authority Auditor Under Investigation…An investigation of the Puerto Rico Electric Power Authority (PREPA) auditor could be crucial for bondholders. Upon U.S. lawmakers’ insistence, the Oversight Board is conducting an independent financial investigation to determine “whether the integrity of any of the accounting services provided by BDO was affected by alleged fraudulent activities of the firm’s former managing partner.” BDO Puerto Rico’s managing partner has been indicted for wire fraud, conspiracy and money laundering. BDO Puerto Rico, which performed a host of audits and accounting for the Island’s government, its Treasury, power utility and highway authority is under investigation. BDO Puerto Rico’s work with PREPA’s audit is critical because it relates to “the accurate representation of PREPA’s financial position, which underlies the representations made to the FOMB, bidders in PREPA’s privatization process, as well as representations to the Title III court regarding PREPA’s bankruptcy and debt restructuring,” U.S. House Natural Resources Cmte Chair Raúl Grijalva and Rep. Nydia Velázquez wrote to the Oversight Board. U.S. House Cmte Chairman Grijalva added “If BDO Puerto Rico is shredding documents, it doesn’t matter at this point if it’s part of a routine schedule. It must stop now. This is a very precarious moment for the credibility of the Island’s government and major institutions. The priority now has to be transparency and integrity.”

Bond Insurer Sues Puerto Rico Bond Underwriters…National Public Finance Guarantee Corp. is the first bond insurer to sue major Wall Street underwriters of Puerto Rico debt. National has paid $720 million in insurance payments to bondholders through July 1, 2019 and is seeking at least $720 million from Citigroup Inc., Goldman Sachs Group Inc., JPMorgan Chase & Co. and other banks that underwrote Puerto Rico debt, claiming they failed to adequately vet Puerto Rico bond deals. In May, the Island’s Oversight Board sued various Wall Street underwriters related to the defunct Government Development Bank. The bond insurer complained that underwriters “betrayed their role as the market’s gatekeepers.”

Puerto Rico Bonds Rally Amid Governance Turmoil…Islanders’ search for a Governor that will be free of corruption has given new wings to Puerto Rico bonds. Puerto Rico bonds have returned over 14% this year. Long overdue, government overhaul is in the making. Puerto Rico Supreme Court’s rejection of Governor Pierluisi’s appointment has led former Justice Secretary Wanda Vázquez to take on the governorship. While the latest appointment fulfils constitutional requirements, it is not an elected mandate. Resident Commissioner Jenniffer González, an elected official, is vying for the top job ahead of the 2020 election. Gonzalez has mustered the support of Senate President Thomas Rivera Schatz and ruling party majority. Senate minority leader hopes the Supreme Court ruling would help Puerto Rico stabilize and “move forward as a democratic people, where the will of the people is always the source of public power.” Many foresee an eventual departure of Vazquez and want Gonzalez installed as next-in-line to Governor Vazquez. Gonzalez has higher credibility in Washington and has played a role in the $42 billion promised federal aid. Meanwhile, Governor Vázquez plans on carrying out her duties as she states, “There is no room in this administration for unreasonable expenses.”Chairman Grijalva, head of U.S. House Cmte in charge of overseeing U.S. territories shared, “The Puerto Rican people are tired of corruption, tired of being taken advantage of, and tired of wrongdoing going unpunished.” Day-to-day Puerto Ricans, U.S. lawmakers, and federal agents have tightened the noose on corrupt politicians. Bond investors look through the confusion and find comfort in the political demands for government accountability.

Compare 30-Year taxable U.S. Treasury yield 2.20% to 30-Year tax-exempt muni bond yield “AAA” 2.13%; “AA” 2.38%; “A” 2.65%; “BBB” 2.9%. For investors in the 35% tax bracket, a 2.9% tax-exempt yield is equivalent to a 4.45% taxable yield. Top rated tax-free bonds yield 97% of comparable taxable U.S. Treasuries.