Puerto Rico Facing Junk Has Worst Year Since ’08: Muni Credit

Debt of Puerto Rico, already facing the worst performance since 2008, is poised to weaken further after the U.S. commonwealth had its credit rating cut to one level above speculative grade.

Investors are demanding the most extra yield in three years to hold bonds sold by issuers from Puerto Rico, which has a debt load 10 times the U.S. average and the nation’s weakest pension system. Moody’s Investors Service last week reduced Puerto Rico’s rating by two levels to Baa3, one step above junk, and signaled it may lower it again.

The commonwealth’s securities, which are tax-exempt in all states, are set to trail the $3.7 trillion municipal market for the first time in four years. Guy Davidson, director of munis at AllianceBernstein LP in New York, said buyers will probably penalize the island as it plans to sell almost $800 million of general-obligation bonds by June 30 as part of a plan to move some bond payments to future years.

“There’s a lot of outstanding Puerto Rico debt already,” said Davidson, who helps manage $32 billion, including some of the commonwealth’s bonds. “There will be market access, but it probably will be at cheaper prices.”

Risk-Reward

With tax-free yields close to a 47-year low, investors have been buying lower-rated munis for their higher yields. Yet Puerto Rico’s downgrade shows the added risk in that strategy. Moody’s rating shift affected $38 billion of debt, including $5 billion worth that has been reduced to junk.

Debt sold in Puerto Rico has earned 5.3 percent this year, compared with 7.3 percent for the broader muni market, according to Barclays Plc data. It would be the first time since 2008 that the commonwealth failed to beat the market.

With Puerto Rico debt exempt from taxes nationwide, many state-specific mutual funds hold the debt. Some funds have restrictions against owning junk securities.

“You would hope that people would have seen this coming and would have made those adjustments in advance,” said Daniel Solender, who helps manage $17 billion of munis, including Puerto Rico’s, at Lord Abbett & Co. in Jersey City, New Jersey. “But there are always some who wait for the news to react, so it’s possible there could be some selling.”

Moody’s cited Puerto Rico’s “reduced prospects for a strong economic recovery,” and the “lack of meaningful pension reform.” The commonwealth cut its economic growth forecast to 0.6 percent from 1.1 percent for the fiscal year ending June 30, according to Moody’s.

Funding Challenge

As of June 30, 2011, Puerto Rico’s Employees Retirement System had assets equaling 6.8 percent of estimated retirement payments, making it the worst-funded in the U.S. Illinois had a ratio of about 43 percent, the lowest among states, data compiled by Bloomberg show.

The commonwealth also had $51.9 billion of net tax- supported debt last year, with $14,004 per capita, about 10 times the U.S. average, according to Moody’s.

Investors were already penalizing Puerto Rico before the downgrade on concern that the commonwealth will struggle to bolster its pensions and balance revenue and spending. Buyers required as much as 2.33 percentage points of extra yield this month to hold 30-year Puerto Rico revenue debt instead of AAAs, the most since October 2009, data compiled by Bloomberg show.

Transition Time

Republican Governor Luis Fortuno, who has cut payrolls to help bridge budget deficits, lost a re-election bid last month against Alejandro Garcia Padilla, a member of the Popular Democratic Party. The new governor takes office Jan. 2.

Commonwealth officials were anticipating that Moody’s and other rating companies would give the incoming administration time to strengthen the pension system and balance budgets.

Juan Carlos Batlle, president of the commonwealth’s Government Development Bank, said in an e-mail that Moody’s action was “irresponsible, untimely and unfair,” and that the company hadn’t indicated “such an adverse action” in conversations with the bank and Fortuno in recent weeks.

David Jacobson, a Moody’s spokesman in New York, declined in an e-mail to comment on Batlle’s statements.

“Moody’s actions further signal the need for fiscal discipline,” Garcia Padilla said in a statement Dec. 14. “My administration will focus on job creation and economic development initiatives, meaningful pension reform, and implementing prudent austerity measures.”

Junk Addition

The $5 billion of Puerto Rico debt lowered to Ba1, one level below investment grade, includes Puerto Rico Aqueduct & Sewer Authority bonds, according to Moody’s.

An aqueduct bond due in 2042 traded Dec. 14 with an average yield of about 5.6 percent, about three percentage points above an index of top-rated debt, data compiled by Bloomberg show. That spread is about 0.4 percentage point more than Dec. 12, the day before the downgrade.

“You’ve already had a selloff of Puerto Rico debt and it’s cheapening more, but it’s issue by issue,” said Lyle Fitterer, managing director at Wells Capital Management in Menomonee Falls, Wisconsin, which oversees about $30 billion of munis.

Some credits are attractive, he said. He bought Puerto Rico Electric Power Authority bonds a day after the downgrade. The debt has bond insurance, Fitterer said. Moody’s didn’t cut that agency’s debt.

“We don’t think it’s going to non-investment grade,” Fitterer said.

Davidson at AllianceBernstein said he’s not ready to jump in, and anticipates the commonwealth’s general obligations may cheapen more.

The securities have “more downside than upside,” he said.

In trading last week, yields climbed the most in more than a year.

The interest rate on 20-year general obligations rose 0.17 percentage point to 3.44 percent, according to a Bond Buyer index. It was the biggest jump since October 2011. The previous mark of 3.27 percent was the lowest since 1965.

To contact the reporter on this story: Michelle Kaske in New York at mkaske@bloomberg.net

To contact the editor responsible for this story: Stephen Merelman at smerelman@bloomberg.net

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