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Longest Puerto Rico Rally Since May Shows Pain Ebbs: Muni Credit

The longest rally in Puerto Rico debt in 10 months signals growing confidence in the struggling U.S. territory’s ability to finance its operations for at least a year.

Securities of Puerto Rico and its agencies are extending gains to a fifth straight week, according to S&P Dow Jones Indices. The Caribbean island is preparing to sell as much as $3.5 billion of general-obligation debt next week, its first such offer in two years, to balance budgets and refinance debt.

As it becomes more likely that the commonwealth will find enough demand for the junk-rated deal, investors are concluding the territory will have cash to pay its bills for the next 15 months, said Daniel Solender, director of munis at Lord Abbett & Co. Bonds of Puerto Rico and its agencies have earned 6.9 percent since Feb. 3, while the entire market has gained 1.4 percent, S&P data show.

The deal “gives them liquidity for a while, and so any near-term default scenario or non-payment would be unlikely,” said Solender, whose company is based in Jersey City, New Jersey, and oversees $15.5 billion of munis.

Puerto Rico is borrowing after the three largest rating companies cut it to junk starting on Feb. 4, citing limited access to capital markets and a shrinking economy. The island’s finances influence the $3.7 trillion municipal-bond market because 70 percent of U.S. mutual funds that focus on state and local debt hold the securities, which are tax-exempt nationwide.

Single Digits

The debt may yield about 9 percent, with investors prepared to submit bids for more than $7 billion, said Michael Walls, who helps manage about $2 billion of high-yield munis at Waddell & Reed Financial Inc. While that interest rate would be below estimates last month of double-digit levels, it would still exceed borrowing costs of comparably rated companies, he said.

“At the end of the day, it’s all a relative deal,” said Walls, whose company is based in Overland Park, Kansas.

A 9 percent tax-free yield would be almost double the interest rate on junk-rated corporate debt. That will attract hedge funds and investors who typically buy taxable bonds, Walls said. An index of company debt in the BB ratings tier yielded 4.74 percent as of March 4, according to Bank of America Merrill Lynch.

March 11

The general obligations are set to price as soon as March 11, according to a person with knowledge of the sale who requested anonymity because terms of the offering aren’t final.

Proceeds will generate sufficient funds through June 2015, according to David Chafey, chairman of the Government Development Bank, which handles the island’s debt transactions.

Initial estimates pegged yield levels for the sale in the low double-digits, Matt Fabian, managing director at Concord, Massachusetts-based research firm Municipal Market Advisors, wrote in a Feb. 18 report.

Yields on Puerto Rico securities reached record highs at year-end as investors speculated that its strained finances would make it harder for the commonwealth to cover a debt burden totaling $70 billion. In a 2013 Moody’s Investors Service study of state debt loads, only California and New York had more gross tax-supported obligations.

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.

Legal Location

In the event of a default on this deal, investors would have the ability to sue the commonwealth in a New York court, a first for Puerto Rico general obligations, according to preliminary documents for the sale.

While Puerto Rico’s constitution guarantees that it must pay its general-obligation bonds before other expenses, the offering documents include 12 pages of “risk factors” for investors.

The list includes the possibility that if Puerto Rico’s economy fails to grow, the island may be unable to pay debt service and provide services at current levels to its residents. In the commonwealth’s last general-obligation sale in March 2012, sale documents didn’t include a section detailing risks.

“In a crisis situation where there isn’t enough money to maintain essential services, bondholders may have to wait to get paid regardless of the constitutional protection,” said Fabian at Municipal Market Advisors.

Relief Option

The self-governing territory is evaluating options in the event that revenue is insufficient to pay debt service, according to the sale documents.

“The commonwealth could seek relief under existing law or under laws enacted in the future regarding restructuring, moratorium and similar laws affecting creditors’ rights, which could affect the rights of holders of general obligation bonds,” according to the documents.

Puerto Rico officials have moved to revive their economy and mend its finances.

Lawmakers have reduced pension benefits, increased taxes and trimmed budget gaps. Governor Alejandro Garcia Padilla, who took office in January 2013, has said he would release a budget for next fiscal year that doesn’t rely on deficit borrowing, ending a practice used in every spending plan since at least 2000.

“This proposed bond issuance will support Puerto Rico’s ongoing and aggressive actions to continue strengthening its fiscal position and will provide additional flexibility as the island continues its progress on economic development and job creation initiatives,” Treasury Secretary Melba Acosta and Chafey said in a statement yesterday.

On Budget

Preliminary revenue collections show that the commonwealth’s budget for the fiscal year ending June 30 is on track. The island collected about $5.3 billion of revenue through February, $96 million more than budgeted estimates, according to Acosta.

The territory’s debt has outpaced a muni rally that drove benchmark 10-year yields to an eight-month low of 2.45 percent yesterday, data compiled by Bloomberg show.

The advance in Puerto Rico debt is the longest since a seven-week rally that ended in May, S&P data show. At the time, municipal yields were close to five-decade lows, spurring investors to take on added risk to boost returns.

Puerto Rico general obligations maturing in July 2041 traded yesterday with an average yield of 7.65 percent, close to the lowest since October, Bloomberg data show. The extra yield above benchmark munis is about 3.9 percentage points.

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