Puerto Rico’s banks have outperformed recently, as the upcoming bond issue looks like it will exceed initial expectations, pulling in as much as $3 billion and providing the commonwealth two years of funding leading into the planned balanced budget in 2016.

Sterne Agee bullish on Puerto Rico banks

“We believe the surge is due to investors’ increasing comfort level with the government’s pending bond issue (de facto bailout) together with the group’s cheap valuations,” write Sterne Agee analysts Todd L. Hagerman and Robert Greene. “Risk/reward remains favorable at current levels in our view.”

Puerto Rico Muni

Interest in the bond offering is growing as investor confidence in Puerto Rico’s recovery grow, and the triple tax-free status (no Federal, state, or municipal taxes) along with yields that could hit double digits are drawing in traditional and non-traditional muni investors. The bond issue will also put the issue of whether Puerto Rico can access capital markets to rest, so ratings agencies won’t feel compelled to downgrade the commonwealth any further and it’s possible that recent downgrades could ultimately be reversed.

Meanwhile, the Commissioner of Financial Institutions doesn’t expect the government downgrade, or even individual downgrades, to have a significant impact on local banks’ profitability. Structural reform is also proceeding apace, as the Supreme Court of Puerto Rico has ruled in favor of proposed civil servant and teacher pension reforms. Most investors think the island’s plan to balance its budget in 2016, a year ahead of schedule, is realistic.

“We remain buyers of each of the Puerto Rico banks including BPOP, FBP and OFG,” write Hagerman and Greene.

Ratings agencies have had minimal impact

When Puerto Rico had its debt downgraded to junk status, there was almost no reaction outside of institutional investors that have mandates to only hold bonds rated as investment grade. Since the decision was based on information that was already priced into existing bonds, the change didn’t affect many investors’ assessment of Puerto Rican munis.

In fact, Puerto Rico’s muni bond yields actually fell in January. Forced selling over the summer and tax selling in December last year had pushed yield spreads so high that Puerto Rican bonds were able to reap the benefits of bond market rally just as Moody’s Corporation (NYSE:MCO) was threatening its downgrade.

While Puerto Rico has taken its debt rating seriously, investors are clearly making their own determinations instead of relying on the ratings agencies to figure out which investments are safe.