March 4 (Bloomberg) -- Puerto Rico debt is set to extend its longest rally in a year as proposals to fix a pension system on the brink of insolvency encourage investors that the U.S. commonwealth is tackling its biggest fiscal challenges.
The island’s bonds, which are tax-exempt in all U.S. states, have lured buyers nationwide hunting for extra yield. Puerto Rico revenue-backed securities due in 2023 yield 2.08 percentage points more than top-rated municipal debt, close to a two-month low, data compiled by Bloomberg show. They have been gaining since mid-January.
Governor Alejandro Garcia Padilla, 41, a Democrat who took office Jan. 2, wants to boost the 6.8 percent funding level of Puerto Rico’s largest pension system and keep the island’s general obligations from being cut to junk. Officials last week recommended steps such as raising the retirement age and employee contributions. If passed by the legislature, the plan would address Puerto Rico’s toughest financial hurdle and sustain the debt rally, said Tom Weyl, director of muni research at Barclays Plc in New York.
“It’s one of the most comprehensive reform plans we’ve seen proposed for a state or local pension plan,” he said.
While local governments nationwide face unfunded pension liabilities after the recession that ended in 2009, Puerto Rico has additional challenges. The commonwealth’s economy grew last year for the first time since 2006, according to the Puerto Rico Planning Board. Its December jobless rate of 14.4 percent was higher than in any U.S. state.
The commonwealth must also absorb federal spending cuts that were set to begin March 1. Under the reductions, Puerto Rico would lose financing for job-search assistance affecting 17,770 residents, and get $4.9 million less in primary and secondary education funding, according to the White House.
Moody’s Investors Service in December cut the island to Baa3, its lowest investment grade, citing the unfunded pension liability and “reduced prospects for a strong economic recovery.” The outlook is negative.
The commonwealth’s Government Employees Retirement System, with 131,361 workers and 116,658 retirees, had 6.8 percent of assets needed for $25.5 billion in projected obligations, according to the most recent actuarial report. Illinois, the weakest among U.S. states, had about 43 percent of needed assets, data compiled by Bloomberg show.
Puerto Rico’s system will run out of net assets in 2014 and total assets, which includes pension-bond proceeds, in 2019, according to the Government Development Bank for Puerto Rico. The governor’s recommendations would extend the life of the system to about 2040, according to the bank, the commonwealth’s fiscal agent.
“As far as the credit goes, this is positive,” said Joseph Pangallozzi, a managing director with New York-based BlackRock Inc., which is the world’s biggest asset manager and handles $109 billion of munis.
If history is any guide, there’s room for Puerto Rico bonds to gain. The additional yield that investors demand to buy 10-year revenue debt sold by Puerto Rico issuers is still wider than the average of 1.4 percentage points since 1996, the data show.
Puerto Rico general-obligation bonds maturing in July 2041 traded March 1 as high as 100.6 cents on the dollar, up from 95.3 cents when the debt was issued in March 2012, Bloomberg data show. The securities yield about 5 percent.
The governor’s plan includes lifting the retirement age in stages, to 65 from 58 for workers who have been in the system the longest, and to 67 from 60 for the newest employees, according to a press release from the Development Bank. Employees would also pay 10 percent of their salaries toward retirement, from about 8 percent.
He would also lower bonuses and direct $100 million per year from the commonwealth’s general fund to bolster the pensions. The changes would give employees hired in 2000 an annuity after retirement rather than a one-time payment.
“Each one of these measures is needed to preserve the system’s solvency and to guarantee our public employees a dignified retirement,” Javier Ferrer, president of the Development Bank, said in a statement.
The proposal would help keep the commonwealth’s general-obligation grade above junk, Weyl said.
“We do look at this as stabilizing the ratings process here,” Weyl said. “The pension is the largest problem that the rating agencies are focused on.”
Puerto Rico debt has earned 3.3 percent this year through Feb. 28, beating all U.S. states and the broader muni market’s 0.7 percent gain, according to Barclays data.
The proposals don’t include selling pension bonds. Puerto Rico had almost $3 billion of such bonds and $9.8 billion of general-obligation debt as of March 31, according to the commonwealth.
Investors still want more information, such as how the changes would affect estimated funding levels, Pangallozzi said.
Betsy Nazario, spokeswoman for the Development Bank, said Ferrer was unable to answer questions about the proposal. Puerto Rico Treasurer Melba Acosta was also unable to comment, said Eva Lizardi, a spokeswoman.
In trading last week in the $3.7 trillion muni market, local debt was little changed, trailing gains in Treasuries. Benchmark 10-year munis yielded about 1.88 percent.
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