Inflation Running Hot and Major Update on Assured Guaranty’s Puerto Rico Exposure

Today the U.S. consumer prices numbers were released.  The numbers topped forecasts significantly, increasing by 0.8% from the prior month, reflecting gains in nearly every major category.  To put it into context, the gain in the overall CPI was twice as much as the highest projection in a Bloomberg survey of economists.  It is clear that we are seeing some of the highest inflation in a decade currently.  How long it lasts, or how far it goes from here, are the biggest questions.

Successfully investing in an inflationary environment requires stock picking acumen.  Higher inflation, means higher rates.  Higher rates destroy bond prices, and tend to lead to multiple contraction on high-flying stocks trading at nosebleed levels, which are plentiful at the current juncture.

Sectors that benefit tend to be commodities, financials, and companies with true pricing power such as a Coca-Cola, Hershey’s, etc.  Tech/Advertising businesses can still do great, but the question is are the business prospects factored in at current prices? Inflation at these levels makes holding a larger than 6-12 month reserve in cash a lot more costly, as the purchasing power of that cash dissolves, while the paltry interest rates fail to keep up.

One stock that is a beneficiary of higher rates is Assured Guaranty (AGO), which is a bond insurance company.  Higher rates lead to more business written and more investment income.  The biggest issue hanging over the company over the last 5-6 years has been its exposure to Puerto Rico bonds, given that the Commonwealth has been engaged in a bankruptcy-like proceeding.  The process was hindered by Hurricane Maria and then of course Covid-19, but the year is off to a great start and the stock is performing really well.  Most importantly, the Federal Oversight Board has had some new blood injected into it, which has been negotiating deals finally.

93% of AGO’s Puerto Rico exposures now has agreements with the Board and the PR government.  Even better, the company did not have to increase loss reserves as these deals were in line with the company’s estimates.  This is a huge opportunity and the market doesn’t fully appreciate the ramifications yet.  The deals still need to be approved by Title 3 Court, which will take some time, maybe towards the end of this year or even 2022, but this is by far the furthest we have come.  This would cut the company’s already lowest below investment grade exposure in history, in half and set the stage for a great period of growth and enhanced profitability in my opinion.  While the stock is up a lot, the current valuation is still immensely low given that the biggest known risk has now been resolved with no new losses.  I’d also mention the other 7% of exposure to Puerto Rico are almost entirely issuances that never stopped paying, so I wouldn’t worry at all about them either. This is a big opportunity in an overvalued market, which of course we are taking advantage of, but of course we must be patient and continue our long-term approach.

Here is a recent research report I wrote on the company: Tim Travis AGO Research Report