Puerto Rico’s Lesson For ETF Investors

May 06, 2016

Should municipal bond ETF investors be worried about what’s going on with Puerto Rico bonds? Probably not.

Should they be aware of it? Definitely.

While the current news about Puerto Rico’s default on its municipal bonds is not a surprise, it is a good demonstration of what political risk looks like to bondholders.

Political risk refers not to an issuer’s ability to pay, but by its willingness to pay and that it can be recognized not only by a specific repudiation of an obligation, but also by an ongoing unwillingness to do what is necessary to be able to pay. Political risk has generally been more of a concern of investors in emerging market bonds than for municipal bonds.

Credit Ratings And Political Risk

The temptation for an issuer to decide not to pay goes up as financial stress accumulates—and in addition to annual budget challenges, demographic trends can be powerful long-term drivers of economic stress (just as demographics may have been the driver behind boom times too).

Because issuers with greater financial flexibility will have less incentive to resort to political means for solving financial problems, credit ratings can offer a reasonable starting point in looking for possible political risk.

However, lower credit ratings should not in and of themselves suggest higher political risk. General obligation bonds and bonds paid from comingled taxes or revenues may be more vulnerable to political risk than essential service and other revenue bonds. Signs of an increase in political risk can include long-term declining economic or credit trends accompanied by an increase or extension in debt.

With economic growth slow and demographics in some parts of the country turning negative, political risk could quietly increase.

However, most borrowers are serious and diligent in how they manage their debt. Notwithstanding the current attention on Puerto Rico, most of the 60,000 issuers in the muni market will never be in the headlines. Political risk may be increasing, but it should remain a low-probability source of investment risk in the municipal bond market.

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