Although the city of Detroit's $18 billion bankruptcy
declaration in 2013 was taken in stride by the stock market, bond
insurance companies lost billions and saw their stocks slide in
This time around, Puerto Rico's current financial struggles
might not be so easily digested by the markets. The island's $72
billion debt burden is so vast that the governor says it is "just
not payable." In response, investors are fleeing shares of the
municipal bond insurers, with losses exceeding 35% for one of the
Yet demand for insurance in the $3.6 trillion municipal bond
market won't be drying up, and the recent selloff maybe a buying
opportunity, at least for investors that can handle higher
volatility and wait for the best of breed to emerge stronger.
Puerto Rico's woes come as no surprise. The popular tax haven
collects no capital gains tax and levies only a 4% tax on its
residents' income. Nearly a decade of economic stagnation has
precipitated an historic migration of residents to the United
States mainland. A third of those born in Puerto Rico now live on
the mainland, and the island is suffering a brain drain on its
The solution up until now: issue more debt. Investor demand
for debt issued by the island was strong for its triple tax
exemption from federal, state and local taxes. Sluggish economic
growth meant the island couldn't retire debt but, with rates
below 6%, it could always just issue new debt to cover the
That is, until credit rating downgrades and other municipal
defaults started scaring investors in 2013. Puerto Rico saw the
yield on its new issues jump to 9% for general obligations bonds
and to 15% for bonds issued by the Puerto Rico Electric Power
Authority ( PREPA).
As far as Washington is concerned, no bailout will be
forthcoming. (Nor was there a bailout for Detroit's bondholders.)
So current bondholders will need to make concessions, something
the island government has already suggested.
The island's political status as a commonwealth does not allow
it to file for bankruptcy as is allowed for individual states. A
bill in Congress that would allow municipalities and public
entities to declare bankruptcy is unlikely to pass since a
bankruptcy would amount to a federal bailout.
This is where the municipal bond insurers come in. More than a
quarter (28%) of the island's debt is insured, which may severely
deplete their capital bases.
One Insurer Survives The Fallout
Shares of bond insurers are getting hammered with
Assured Guaranty Ltd. (NYSE:
down 17%, MBIA, Inc. (
) down 39% and Ambac Financial Group, Inc. ( Nasdaq: AMBC) down
nearly 29% in just the past few weeks.
The total amount of Puerto Rican exposure at the three
insurers topped $11.8 billion at the end of 2014. Ambac Financial
and MBIA's exposure is greater than their statutory capital.
Statutory capital is the amount of liquid assets required to
cover insurance exposure and stay in business.
An eventual agreement with creditors will determine the true
extent of these firms' exposure. The city of Detroit reached a
settlement that saw bond insurers pay about $0.26 on the dollar
for insured bonds. A similar settlement for Puerto Rico would
still mean billions in losses, but could actually leave one
insurer in a stronger position.
The relatively smaller exposure as a percentage of capital at
Assured Guaranty should mean that it can weather the process of a
Puerto Rican restructuring. Since insurers' profits depend
heavily on their credit rating and the cost they pay for debt,
emerging from the situation relatively unscathed could see the
company's rating upgrade, which would lower the firm's own cost
of capital and lead to higher levels of profitability.
Thanks to the recent pullback, shares of Assured Guaranty
trades for just 0.6 times book value against a five-year average
of 0.8 times book. The shares are likely to see more pressure as
the Puerto Rican debt restructuring story develops, but investors
may want to start strategically buying into a position. The
shares pay a 1.9% yield and could be worth nearly $30 on any sign
that the company will avoid a major fallout from the Puerto Rican
Risks To Consider:
Even relatively healthy Assured Guaranty could see further
weakness as the story of Puerto Rico's default develops.
Long-term investors should stagger their position to take
advantage of potentially lower prices without trying to time a
Action To Take -->
Take advantage of a sell off in Assured Guaranty on the imminent
restructuring of Puerto Rico's debt to buy a long-term position
in the shares.
Just because Puerto Rico might be a mess right now,
doesn't mean you should ignore other investing opportunities
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