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Puerto Rico Going From Bad to Worse Lowers CDS Risk: Muni Credit

Buildings stand in Old San Juan in San Juan
Puerto Rico debt gained 3 percent last week, the most since October, after commonwealth officials laid out plans for their bond sale, S&P Dow Jones Indices show. Photographer: Christopher Gregory/Getty Images

Feb. 24 (Bloomberg) -- The cost to protect against U.S. municipal defaults is the lowest in five months as investors anticipate a planned $2.86 billion Puerto Rico borrowing will ease the island’s cash needs.

Puerto Rico, the third-largest municipal borrower behind California and New York, plans an offering in March that would raise enough funds to last through mid-2015, David Chafey, chairman of the island’s Government Development Bank, said on a webcast last week. The bank handles bond sales for the U.S. territory of 3.6 million people.

Munis, including Puerto Rico debt, have rallied since Feb. 4, when Standard & Poor’s led the three biggest rating companies in cutting the island’s credit to junk. Investors anticipated the move, driving yields to speculative-grade levels last year. Puerto Rico’s finances influence the entire tax-free market because 70 percent of mutual funds that focus on local debt hold the island’s securities, which are tax-exempt nationwide. The rally has helped lower the cost of insuring against municipal defaults, said Mikhail Foux, a credit analyst at Citigroup Inc.

“Investors are much less concerned about near-term problems,” Foux, who’s based in New York, said about Puerto Rico’s ability to pay its debt. “We’re talking about a substantial amount of liquidity that they’ll get for a long period of time.”

Falling Cost

Puerto Rico debt gained 3 percent last week, the most since October, after commonwealth officials laid out plans for their bond sale, S&P Dow Jones Indices show.

It costs the annual equivalent of as little as $126,667 last week to protect $10 million of munis for five years through credit-default swaps, the lowest since September, according to Markit Group Ltd. data.

That’s down from a three-month high of about $146,000 on Jan. 29, before the S&P downgrade. The cost exceeded $250,000 in 2010, in the wake of the longest recession since the 1930s.

Defaults have declined in the past two years. Sixty municipal issuers defaulted in 2013 for the first time, down from 126 in 2011, according to research firm Municipal Market Advisors in Concord, Massachusetts.

Credit default swaps are contracts that pay the buyer face value if a borrower fails to meet obligations, less the value of the defaulted debt. The Markit MCDX index includes 50 such contracts of tax-exempt issuers, excluding tobacco and health-care securities.

Sale Risk

Credit-default swaps specific to Puerto Rico have also fallen in price. It cost about $682,000 annually to hedge $10 million of commonwealth debt for five years through the contracts, close to the lowest since early January, according to data provider CMA, which is owned by McGraw Hill Financial Inc. and compiles prices quoted by dealers in the privately negotiated market.

Prices on the contracts have dropped even with the risk that Puerto Rico’s second attempt to issue since August won’t happen. Soaring yields halted a plan to sell sales-tax debt last quarter.

If Puerto Rico is unable to access capital markets or balance its budget for the fiscal year beginning July 1, “then the financial condition of the commonwealth may deteriorate further and its options to improve its fiscal health may be limited,” according to a quarterly update on Puerto Rico’s finances dated Feb. 18 and posted on the GDB’s website.

Fund Demand

Demand will come from hedge funds and investors who typically buy taxable securities as the debt may carry double-digit yields, Matt Fabian, a managing director at Municipal Market Advisors, wrote in a Feb. 18 report.

With the downgrade to junk behind Puerto Rico and a plan to raise more funds, investors who bought default protection can sell for a profit, said Bart Mosley, co-president of Trident Municipal Research in New York. The price on Puerto Rico credit-default swaps was as low as $485,000 on July 31.

“It’s the only vehicle that people have had to place a bet on further deterioration in the credit,” Mosley said. “Now you’ve got the downgrades, how much more are you expecting?”

Hedge funds have been buying Puerto Rico securities since at least September as yields climbed on concern that the commonwealth and its agencies would be unable to repay in full $72 billion of debt. The island’s economy has shrunk 14 percent since 2006 and its 15.4 percent jobless rate in December was more than double the national average.

Rebound Time

Puerto Rico securities lost about 20 percent in 2013, the worst year since at least 1999, S&P Dow Jones Indices show. The debt has rallied in 2014, earning 5.5 percent, surpassing the 2.7 percent gain for the broader muni market.

Puerto Rico general obligations due in July 2041 traded Feb. 21 with an average yield of 7.89 percent, close to the lowest since November, data compiled by Bloomberg show. The extra yield investors demand over benchmark munis was 4.03 percentage points.

After the cut to junk, Markit will remove Puerto Rico securities from its MCDX index when it creates a new version in April, Citigroup’s Foux said.

Markit will announce changes before the new index begins on April 3, Alex Paidas, a company spokesman, wrote in an e-mail. Credit ratings are a criteria for inclusion, he wrote.

Separating Puerto Rico from the MCDX will create a better way to gauge the value of commonwealth swaps, Foux said. There would be two MCDX indexes to compare: the prior one with Puerto Rico securities and the new one without them.

Investor Tool

That may increase trading of Puerto Rico bonds and MCDX, Foux said. Investors would be able to buy Puerto Rico securities and hedge them with the MCDX that includes commonwealth debt, he said. Investors would also be able to short Puerto Rico, meaning bet against it, through the indexes.

Trading in municipal derivatives is a fraction of the activity in corporate swaps.

About $180 million of swaps on the MCDX traded during the week ending Feb. 14, compared with $157 billion for Markit CDX North America Investment Grade Index, which consists of 125 corporate swaps, according to The Depository Trust & Clearing Corp.

To contact the reporter on this story: Michelle Kaske in New York at

To contact the editor responsible for this story: Stephen Merelman at

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