Puerto Rico Removal Fuels Record Drop in Risk Index: Muni Credit

The price of protecting municipal bonds against default is dropping by an unprecedented amount, signaling that investors are separating Puerto Rico’s economic woes from a broader fiscal rebound by states and localities.

It cost the annual equivalent of $72,500 yesterday to protect $10 million of munis for five years through instruments known as credit-default swaps, the lowest since 2008, according to data provider CMA. The price fell by a record $33,000 April 3 after a periodic reset of Markit Group Ltd.’s 50-member muni index. As part of the update, Puerto Rico’s general obligations and electric-revenue bonds were removed because the commonwealth was cut to junk in February.

The cheapening underscores an economic recovery among U.S. states and cities since the recession ended almost five years ago. Defaults fell to the lowest since 2009 last year and “will remain rare and isolated” as home prices stabilize and tax revenue grows, according to a report this week from Concord, Massachusetts-based Municipal Market Advisors.

“Investors looked at the composition of the index, and without those two entities, credit quality is pretty solid,” said Mikhail Foux, a credit analyst at Citigroup Inc. in New York. Compared with its corporate counterpart, “we have a much safer index and it trades at substantially wider spreads.”

Rally Leader

The $3.7 trillion municipal market has outpaced a broad fixed-income rally this year, leaving municipal yields close to a five-decade low. Local bonds fell last year as concern that interest rates would rise converged with Detroit’s bankruptcy filing and bets that Puerto Rico’s slowing economy couldn’t support its debt burden.

The island of 3.6 million people lost its investment grades from Standard & Poor’s, Moody’s Investors Service and Fitch Ratings in February, before it issued $3.5 billion of general obligations last month in a record muni junk-bond offering. Speculative-grade issuers are ineligible for Markit’s municipal credit-default swap index, known as MCDX.

Institutional buyers such as hedge funds are among the biggest users of the swaps. An investor or bank pays a fee for protection against a credit event, which includes a missed debt payment or restructuring. Buying the instrument is equivalent to betting a security’s price will drop.

Chicago Joins

The index updates every six months, in April and October. This is the first time its composition has changed, Ed Canaday, a spokesman for Markit in New York, said in an e-mail. The price is still about 11 percent higher than the index tracking investment-grade company debt, according to CMA, which is owned by McGraw Hill Financial Inc. and compiles prices quoted by dealers in the privately negotiated market.

General obligations from Chicago and Philadelphia, which Moody’s rates Baa1 and A2, respectively, replaced the Puerto Rico securities in the MCDX index.

The index includes state general obligations from Hawaii to Maryland, transportation issuers such as New York’s Metropolitan Transportation Authority and education borrowers including the University of Texas System.

Among U.S. states, 48 reported increased tax revenue in fiscal 2013 compared with 2012, and nationwide collections rose 6.1 percent from the prior year to a record $846.2 billion, the Census Bureau said this week.

With revenue growing along with the economy, states such as California, Florida and Minnesota project surpluses for the coming year, giving officials a chance to cut taxes, save money or increase spending on programs cut in prior years.

Comfort Level

At the local level, all but seven of 363 metropolitan areas will see economic gains this year, including areas that struggled to rebound from the recession, according to a January report by the U.S. Conference of Mayors.

“Overall relative credit quality has improved and that shows in the price” of the swaps index, said Justin Formas, director of credit research in Chicago at Bernardi Securities Inc., which oversees about $1 billion in munis. “There’s more specific-name credit events versus speculation on the overall credit quality of the market.”

Just as municipal bonds exchange hands less frequently than Treasuries and corporate debt, the MCDX index has smaller trading volume than those tracking company securities.

In the three months through Dec. 19, the newest MCDX series traded on average four times a day for $75 million, according to data from the Depository Trust & Clearing Corp. By comparison, the North American investment-grade company index traded 419 times for $24.6 billion.

Trading volume jumped April 4 on the muni index without Puerto Rico, known as series 22, to $130 million across five trades, the highest in a month, according to Markit.

By taking out Puerto Rico, “you have a broad muni market index that is effectively trading at the lowest level in five or six years,” Foux said. “I would even say it could trade tighter to corporates.”

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