March 22 (Bloomberg) -- Puerto Rico, on the brink of being cut to speculative grade, is rallying the most in a year as investors bet that the 11-week-old administration of Governor Alejandro Garcia Padilla will mend the commonwealth’s finances.
Moody’s Investors Service, Standard & Poor’s and Fitch Ratings mark Puerto Rico general obligations, which are tax-exempt in all U.S. states, one step above junk with a negative outlook. The island’s budget gap for the fiscal year ending June 30 has almost doubled to $2.2 billion, Moody’s estimates. Its largest pension system will run out of cash in 2014, according to the Government Development Bank for Puerto Rico.
Even with rating downgrades that began in December, debt of the self-governing U.S. territory is earning 2.6 percent this year, more than 10 times the gain for the $3.7 trillion municipal market, Barclays Plc data show. The yield penalty on revenue-backed bonds of commonwealth issuers has shrunk to the least since September, data compiled by Bloomberg show. Puerto Rico will pay its debts even if it drops to junk, said Daniel Solender at Lord Abbett & Co. in Jersey City, New Jersey.
“While that’s clearly not a positive, it’s still a long way from being a default situation,” said Solender, who helps manage $19.5 billion of munis.
The Development Bank, the commonwealth’s fiscal agent, is set to meet investors today in New York to discuss the fiscal challenges, said Betsy Nazario, a spokeswoman.
Puerto Rico’s rally, following December losses, shows the tradeoff of lower-rated credits. Investors have been buying riskier munis in search of extra yield as interest rates on 20-year general obligations remain about 20 percent below their average since 1993, Bond Buyer data show. Yields set a 47-year low in December.
The territory’s debt is held in national portfolios as well as high-yield and single-state funds. General obligations sold last year and due in July 2041 were the most frequently traded muni security in 2012, according to the Municipal Securities Rulemaking Board. Bonds from Puerto Rico accounted for six of the 10 most-traded securities.
The risk of the commonwealth’s falling below investment grade has already been priced into the bonds, Solender said. The general obligations due in July 2041 traded yesterday with an average yield of about 5.4 percent, or about 0.4 percentage point above an index of 30-year BBB munis, Bloomberg data show.
“They’re trading at much higher yields than other BBB bonds,” Solender said. “So the market’s already trading them as if they’re lower-rated.”
Bondholders have refrained from selling Puerto Rico securities this year because of the higher relative yields and because they’re waiting to hear from the financial officials before adjusting portfolios, said Lyle Fitterer, who oversees about $31 billion of munis as a managing director at Wells Capital Management in Menomonee Falls, Wisconsin.
Puerto Rico needs to sell refinancing debt in the next three months. The fiscal 2013 budget counts on selling about $775 million of bonds by June 30 to push principal and interest payments to future years, according to Javier Ferrer, president of the Development Bank.
The island hasn’t sold bonds since November, Bloomberg data show. Officials wanted to wait for the governor to release his plan to strengthen the island’s retirement fund before borrowing, Ferrer has said.
Garcia Padilla, 41, of the Popular Democratic Party, took office in January. His administration last month announced a proposal to raise the retirement age, increase employee contributions and direct $100 million annually from Puerto Rico’s general fund to boost the pension system’s 6.8 percent funding level. By comparison, Illinois had about 43 percent of needed assets, the weakest ratio among states, Bloomberg data show.
The last time Puerto Rico issuers went through the first quarter of the year without selling debt was in 2003, Bloomberg data show. Island issuers had sold $5.8 billion of debt at this time last year.
The diminished supply is helping commonwealth bonds. Puerto Rico’s total return this year compares with a 0.2 percent gain for the broader market and beats all states, Barclays data show.
Investors demand 1.95 percentage points of additional yield to buy 10-year revenue-backed debt from Puerto Rico, the lowest penalty since September and down from 2.25 percentage points on Jan. 14, Bloomberg data show. The last time the yield spread shrank more was March of last year.
To address this year’s deficit, the administration plans to reduce spending, pursue delinquent taxpayers and accelerate certain 2014 corporate revenue into the current year, according to Moody’s. The commonwealth may need additional borrowing to help close the gap, the company said. It already has about $14,000 of net tax-supported debt per capita, about 10 times the U.S. average, according to Moody’s.
The preliminary size of Puerto Rico’s budget for the fiscal year starting July 1 is about $9.8 billion, with a projected deficit of $1.4 billion, according to Moody’s.
“We’re not saying they’re going to default on their debt any time soon,” Fitterer said. “But looking at them from a financial perspective, it’s hard to argue that you couldn’t see further downgrades.”
While Puerto Rico has been absent from the market, localities nationwide are offering about $10 billion this week, the year’s busiest period. The wave is helping keep muni yields above those of Treasuries for seven straight days, the longest span since December, Bloomberg data show.
At 2.03 percent, yields on benchmark 10-year munis are close to an 11-month high and compare with 1.91 percent on federal securities, Bloomberg data show.
The ratio of the two interest rates is about 106 percent, compared with an average of about 92 percent since 2001. As that percentage rises, local bonds become cheaper relative to Treasuries.
Still, muni investors aren’t signaling concern about credit quality.
It costs the annual equivalent of about $151,000 to protect $10 million of munis for 10 years through credit-default swaps, close to the lowest since mid-2011, according to Markit Group Ltd. index data compiled by Bloomberg.
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