Puerto Rico Junk Grades Spur Barclays Index Shakeup: Muni Credit

Puerto Rico’s downgrade to junk by a second ratings company is set to realign $13 billion of debt in Barclays Plc (BARC) indexes that serve as benchmarks for most municipal mutual funds.

The company’s broadest muni index requires that for issuers with three ratings, two must be investment grade. The U.S. commonwealth was cut to junk by Standard & Poor’s on Feb. 4 and by Moody’s Investors Service three days later. Puerto Rico bonds represent 2.5 percent of the $1.28 trillion Barclays benchmark, the bank said in a Feb. 4 report.

The downgrades will alter benchmarks used by 82 percent of municipal mutual funds, including nine of the 10 largest, Morningstar Inc. (MORN) data show. The island’s presence in the indexes may have prevented some selling, said Peter DeGroot at J.P. Morgan Securities LLC and Bart Mosley at Trident Municipal Research. Its removal would give investors one less reason to own the securities after the biggest losses since at least 1999.

The Tale of Puerto Rico's Slide

“Portfolio managers have had to think long and hard about not having some Puerto Rico exposure because they’re giving up that extra yield that’s in the index,” Mosley said. “If it falls out of the index after the other agencies downgrade them, they won’t have that incentive to own it.”

Exit Sign

About $13 billion of Puerto Rico debt may exit the broad Barclays muni index at month-end after the rating cuts, according to the bank’s report. About 70 percent of U.S. municipal-bond mutual funds hold the island’s securities, which are tax-exempt nationwide. The ownership, even in state-specific funds, gives the commonwealth’s finances outsized influence in the $3.7 trillion local-debt market.

Fitch Ratings, which assigns the self-governing commonwealth the lowest investment grade, said in November that it may drop it to junk by June 30. Speculative grade begins at BB+ for Fitch and S&P, and at Ba1 for Moody’s.

Puerto Rico and its agencies have $70 billion of debt, according to the island’s Government Development Bank, which handles bond sales. In a 2013 Moody’s study of state debt loads, only California and New York had more gross tax-supported obligations. The burden, coupled with an economy that contracted in six of the last seven years, has fueled concern that the island won’t be able to repay investors.

Yield Guide

Commonwealth securities have traded at yields consistent with speculative-grade bonds since at least September.

General obligations maturing in July 2041 traded today with an average yield of 8.15 percent, down from 8.24 percent on Feb. 7 and the lowest level since November, Bloomberg data show. The securities yielded about 5 percent a year ago.

Investors have held Puerto Rico in part because “you don’t want to have an index that has a yield that’s higher than your fund,” said DeGroot, a strategist at J.P. Morgan in New York. “Given the compounding nature of total returns, you can very quickly trail your benchmark by a significant amount in those instances.”

The speculative ratings may limit buyers for Puerto Rico because some funds require managers to purchase investment-grade obligations.

For example, at OppenheimerFunds Inc., if all three major rating companies grade the commonwealth junk and that leaves funds with more speculative-grade debt than prospectuses allow, managers won’t be able to add high-yield until the allocation falls to acceptable levels, according to a statement on the asset manager’s website.

The company is the largest holder of Puerto Rico debt among mutual funds, data compiled by Bloomberg show. Kristen Prestano, a spokeswoman, said no fund managers were available to comment.

Future Liquidity

“Most funds don’t have to sell on one or two downgrades,” said Matt Fabian, a managing director at Concord, Massachusetts-based Municipal Market Advisors. “It’s not so much about who holds the bonds now -- the question for Puerto Rico is who’s going to provide liquidity and capital to purchase the bonds in the near future.”

Puerto Rico Governor Alejandro Garcia Padilla and lawmakers are working on a bill authorizing as much as $3.5 billion of general-obligation debt, Representative Rafael “Tatito” Hernandez said last week. Soaring interest rates last year halted issuance of as much as $1.2 billion of sales-tax bonds.

Puerto Rico officials have said the commonwealth has enough liquidity to satisfy all its needs until June 30, the end of the fiscal year.

‘Strongly Disagree’

“We strongly disagree with Moody’s decision, and we will not relent in our plans to strengthen our fiscal situation,” GDB Chairman David Chafey and Treasury Secretary Melba Acosta said in a statement on Feb. 7.

“We remain confident that we have the liquidity on hand to satisfy all liquidity needs until the end of the fiscal year, including any cash needs resulting from recent rating agency actions,” they said.

Of the bonds that could leave the Barclays index with two downgrades, about $4.9 billion are general obligations, $3.3 billion are from the electric power authority, $2.2 billion from the public buildings authority, $1.3 billion from the highways agency, $1.1 billion from the infrastructure financing authority and $500 million is debt from other agencies, according to Tom Weyl, director of muni research at Barclays in New York.

Sales-tax-backed bonds, known as Cofinas, along with pre-refunded debt and securities backed by units of Assured Guaranty Ltd. (AGO) and MBIA Inc. (MBI) will probably keep their investment grades, Weyl wrote in the report. He declined to comment beyond the research.

Adjustment Phase

Puerto Rico will comprise 21 percent of Barclays’ high-yield index after the company adjusts it following the second downgrade. That would be up from 5 percent and would give the commonwealth the largest weighting among states.

Eight muni mutual funds use the broad high-yield index as a benchmark, compared with 262 for the broad index, Morningstar data show.

Removing Puerto Rico bonds will lower interest rates on investment-grade indexes. For example, taking out Electric Power Authority debt would drop the yield on the index tracking the electric power industry to 2.63 percent from 3.02 percent, according to Barclays.

S&P removed bonds from Puerto Rico and other triple tax-exempt territories such as Guam and the Virgin Islands from its National AMT-Free Municipal index as of Jan. 31.

To contact the reporter on this story: Brian Chappatta in New York at bchappatta1@bloomberg.net

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

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