Bond Insurers Surviving Puerto Rico Default Lures Bulls: Options

Jul 28, 2014 4:46 am ET

(For an options column news alert: SALT OMA.)

July 28 (Bloomberg) -- Bad news for Puerto Rico may be good news for Assured Guaranty Ltd., as options traders bet the bond insurer will withstand a possible default by the island’s main electricity provider.

Assured, which backs $852 million of debt issued by the Puerto Rico Electric Power Authority, has seen its shares decline 13 percent since June 19. Trading in the options market is signaling a rebound, with calls trading near the most expensive level to puts in 20 months. The contract with the highest ownership is betting on a 29 percent rally by January, data compiled by Bloomberg show.

Puerto Rico lawmakers approved a bill last month allowing public corporations to restructure debt, and if Prepa defaults, Assured has said it faces a maximum payout of about $65 million a year over a decade. That would be an opportunity for the company to demonstrate the ability to meet claims and bolster its reputation after the 2008 financial crisis led investors to question the reliability of bond insurance.

“Even if it ultimately takes a loss in Puerto Rico, it could be a good loss that would be a testament to the value of insurance,” Mark Palmer, an equity analyst at BTIG Research in New York, said via phone on July 23. “Assured has the wherewithal to not only absorb the impact of a negative outcome at Prepa, but still keep streaming along.”

Interest Payments

Prepa may miss a January interest payment to investors, according to Municipal Market Advisors, potentially triggering a restructuring larger than any by a state or local U.S. government. Investors including BlueMountain Capital Management LLC and Oppenheimer Funds Inc. have asked a U.S. court to block the new Puerto Rico law allowing the restructuring.

If the Puerto Rico power company was to pay less than the bonds’ original prices, insurers such as Assured Guaranty and MBIA Inc.’s National Public Finance Guarantee Corp. would be forced to make up that difference with investors holding insured securities. Other bondholders don’t have that extra security.

Exposure to toxic mortgage-backed securities decimated the bond insurance industry in 2008, as guarantors such as Assured, MBIA and Ambac Financial Group Inc. lost their coveted AAA- ratings, and all but Assured halted business.

The percentage of bonds that carry insurance had the first quarterly increase after at least six years of declines, according to data compiled by Bloomberg. Standard & Poor’s lifted its credit ratings for Assured in March and making investors whole on defaulted Prepa bonds could strengthen the company’s brand, Marc Cohen, an analyst at S&P, said in a phone interview last week.

Calls, Puts

Calls betting on a 10 percent rise in Assured shares cost 0.09 point more than puts betting on a similar-sized loss, the highest level since November 2012, according to data compiled by Bloomberg on six-month contracts.

“The fallout from this Puerto Rico bankruptcy story might not be as large as the market priced in,” Jared Woodard, a senior equity derivatives strategist at New York-based BGC Partners, said by phone on July 25. “What we saw in Assured and MBIA options may have been a bounceback reaction.”

A call and e-mail sent to Prepa’s investor relations office was not immediately returned. Robert Tucker, managing director of investor relations at Assured Guaranty, declined to comment on the options trading.

Among the 10 options with the highest open interest, six are calls. January $30 calls and October $27 calls had the highest open interest among bullish contracts. The stock declined 1 percent to $23.21 last week.

Prepa Default

The Chicago Board Options Exchange Volatility Index, the gauge of S&P 500 options prices known as the VIX, jumped 5.2 percent to 12.69 last week.

A default by Prepa won’t help bond insurers, according to Stanislas Rouyer, an analyst at Moody’s Investors Service in New York. The rating company this month changed its outlook on the company’s Assured Guaranty Corp. unit’s A3 rating to “negative” and retained a “negative” outlook on its Baa1 grade for the firm’s Assured Guaranty Re Ltd. unit, leaving other divisions with stable outlooks.

“Assured or MBIA paying claims on a potential Puerto Rico default may not necessarily increase the perceived value of the product,” Rouyer said in a July 25 e-mail. “The fact that solvent guarantors pay claims is not new.”

The company is probably already setting money aside to prepare for a default, according to Sean Dargan, an equity analyst at Macquarie Capital USA Inc. Assured increased U.S. public finance-related reserves to $281 million on March 31 from $264 million in December, according to company filings.

“Assured will probably take some losses on Prepa because it will likely restructure, but it’s not a stock that’s totally tied to Puerto Rico,” Dargan said in a July 24 phone interview.

--With assistance from Christie Smythe in Brooklyn and Michelle Kaske in New York.