Puerto Rico is either close to default or pulling through with enough liquidity to benefit from the US recovery (no one would argue the island is doing great), but Moody’s Corporation (NYSE:MCO) has threatened a downgrade and everyone knows the risk in Puerto Rican muni bonds is high, so it’s strange that the yield has fallen since the beginning of the year.

Puerto Rico’s yields drop during broader muni rally

This comes in the context of a broader muni bond rally, with concerns about Fed policy driving a flight to quality, concerns about a tactical correction in equities, and the normal January effect (buying bonds again after tax selling in December) have all helped the bond market, but considering the market’s sentiment towards Puerto Rico you wouldn’t expect it to be part of the rally.

“During the period of sharp muni fund outflows, especially from June through September, bond funds that owned Puerto Rico paper were forced to liquidate holdings at least equal to the pro rata amount of their outflows. If they were attempting, in addition, to reduce their proportion of Puerto Rico holdings as that sector got hit, they had to sell even more,” explains Citi analyst George Friedlander.

Then in December, when the entire muni market typically comes under pressure for tax selling, there were concerns that Puerto Rico might be unable to find new financing at all if the need arose. Moody’s Corporation (NYSE:MCO) mid-December demand, that Puerto Rico issue bonds even when it claims not to need them just to prove that it can, ratcheted up the liquidity concerns even more.

“By year end, there were real questions about the Commonwealth’s capacity to bring a new deal to the public markets, except at distress levels with thinking in the 10% yield range,” Friedlander writes.

Confidence that Puerto Rico can access financing has returned

But now that the rest of the market is healthier, and Morgan Stanley has been putting together a reported $1.5 billion financing deal of its own accord, investors have regained confidence that Puerto Rico can access financing if it needs to, possibly at 70-80 basis points below the 10% Morgan Stanley was offering.

“Since market access and fund flow questions had had helped push Puerto Rico paper into an oversold position, a reduction in fund outflows, combined with the rally in munis generally, had a greater impact on Puerto Rico paper in the secondary market than on any other sector,” Friedlander writes.

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