Puerto Rico's Debt Downgrade: Another Shoe Drops

NEW YORK (MainStreet) — It's been a storm brewing for months. Puerto Rico has been an island slammed by a fiscal firestorm, culminating with an S&P downgrade of Puerto Rico's debt to "junk" status this week. How will the tax-free bond market react to this latest setback?

Peter Hayes, head of BlackRock's Municipal Bonds Group, offers a surprising answer: "We don't expect it will be very meaningful to the broader market at all. The downgrade was not at all unexpected. There has been a large disconnect between the rating agencies' assessment of Puerto Rico's debt and the market's view. In fact, Puerto Rico bonds have been trading as non-investment grade since last summer, so the new BB+ rating is actually a better reflection of the island's credit profile and pricing."

The triple-tax-exempt status of Puerto Rican bonds makes them a particular favorite of muni investors, who have seen their island investments pounded by rough seas.

"Whereas the broader municipal market was down 2.55% last year, Puerto Rico was down 20.47%," Hayes says. "Clearly, investors had taken notice. Many actually sold down their positions over the course of the summer and fall, giving those that hung on ample time to position for the downgrade."

In addition, S&P Dow Jones removed all U.S. territories, including Puerto Rico, from its investment-grade indices last month, triggering investment-grade index products to sell their Puerto Rico exposure. Hayes says that has also relieved current selling pressure.

Shawn P. O'Leary with Nuveen Asset Management agrees that the downgrade has been "priced-in" to the market, but warns of increasing volatility.

"Because Puerto Rico debt benefits from triple tax-exempt status, it can be purchased for state-specific portfolios," O'Leary says in a market analysis. "Such portfolios could see greater than normal redemptions and/or price volatility."

Addressing the risk of a Puerto Rican bankruptcy, O'Leary is confident that won't happen, but the alternative could be worse.