With near record inflows into muni-bond funds in recent months, there’s reason for optimism in a sector that continues to be viewed as a solid alternative for Americans seeking tax-advantaged investments.

That doesn’t mean that leading investors in the muni market aren’t troubled by the shadow cast over the sector by Puerto Rico’s historic 2017 bankruptcy and the ensuing governmental and judicial response.

Speaking at AFGI’s recent Puerto Rico Bankruptcy Risk Summit in New York City, a panel of fund managers and investment analysts said that the way they judge individual bonds across the U.S. has been fundamentally altered by what happened on a U.S. island-territory in the Caribbean Sea. During a lively 45-minute discussion, the investment professionals discussed topics ranging from whether there are signs that the muni market has applied a penalty to bonds that share characteristics with Puerto Rico’s debt to the impact on the retail investor as credit analysis becomes increasingly complicated.

“What has changed the most in my career is how the political calculus percolates to the surface,” said Hector Negroni, Chief Executive Officer and Chief Investment Officer of FCO Advisors LP.

“The corporate bankruptcy bar has planted their flag in the municipal market,” said Tom McLoughlin, Head of Fixed Income Americas at UBS Financial Services. “They have stormed the beach and they are now with us forever.”

While the panelists conceded that visible impacts to the market from legal decisions emanating from Puerto Rico’s attempts to reduce its debt in bankruptcy have been muted to date due to a strong U.S. economy and low interest rates, they fear that there will be a reckoning when the market inevitably turns downward.

“The real risk will come when we have an economic recession,” said McLoughlin. He noted that there’s been a narrowing of bond spreads as demand is strong for muni bonds and investors are “diving into the last great tax shelter in America.” And that tax-shelter advantage grew following the passage of historic federal tax legislation in late 2017 that, among other provisions, lowered property-tax deductions.

“But at some point, when the economic recession hits, the chickens will come home to roost,” said McLoughlin.

The panel, which also included Steve Hlavin, Senior Vice President and Portfolio Manager at Nuveen, noted that retail investors are particularly ill-equipped to do the kind of fundamental credit analysis that will be required going forward as the line between the creditworthiness of a revenue bond and its underlying issuer becomes increasingly blurred in the wake of several court decisions in the bankruptcy case.

With retail investors providing much of the liquidity in the muni market, the panel also wondered about the impact on the market should those investors begin heading for the exits. Questions were also raised about the possibility that issuers, deprived of a potential financing tool when their own credit comes under pressure — revenue bonds backed by a dedicated revenue stream — will lose an important source of financial flexibility.

Much of the panel’s discussion centered on how bankruptcies in Detroit and Puerto Rico — and the ensuing response by courts and government leaders — has eroded investor faith in that most classic of muni securities: the general obligation bond.

“GOs will never come back and have the same definitional quality that we saw a decade ago,” asserted one panelist.

During the question-and-answer session, the panel took a question that was critical of the role played by hedge fund managers during the court battles that followed Puerto Rico’s bankruptcy.

“What’s lost when people talk about hedge funds is the marginal capital that they provide to the muni marketplace in an otherwise passive, long-only marketplace,” said FCO’s Negroni. “All those investors who wanted to sell at 90 or 80 or 70 could. You need the marginal buyer to exist to manage the flow in the marketplace.”