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Investors See Turning Point on Puerto Rico Billions: Muni Credit

Puerto Rico debt is off to its best annual start since 1999 as it wraps up a $3.5 billion offering that will address the island’s funding needs and ease credit concern across the municipal landscape.

The $3.7 trillion market’s biggest sale ever of junk-rated securities shows that the U.S. commonwealth can borrow through capital markets even after losing its investment grades last month. The financing is coming at a price. The issuance is set to yield about 8.73 percent on debt maturing in July 2035, data compiled by Bloomberg show. For top earners, the taxable-equivalent yield eclipses that on similarly graded company debt.

The commonwealth and its agencies have $72 billion of bonds that have lured buyers because they’re tax-free nationwide. About 70 percent of U.S. muni mutual funds hold the securities, according to Morningstar Inc. The sale gives the island of 3.6 million people enough cash through June 2015 and time to revive a shrinking economy. Its fiscal woes helped fuel a record wave of fund withdrawals last year.

“Any sort of contagion risk or concerns about panic-selling of all municipal assets, simply because of Puerto Rico, that risk is going down” once the bonds are sold, said John Miller, co-head of fixed income at Chicago-based Nuveen Asset Management LLC, which oversees about $90 billion of munis. “That’s actually good for munis as a whole.”

Budget Move

Puerto Rico is selling general obligations for the first time in two years after record-high yields blocked plans to issue sales-tax bonds last quarter. Proceeds from the offering will balance budgets and repay debt. In a 2013 Moody’s Investors Service ranking of state debt loads, only California and New York had more gross tax-supported obligations.

Barclays Plc is the lead underwriter on the deal, which matures in 2035. The sale comes about five weeks after Standard & Poor’s lowered the island to BB+, the highest speculative grade, citing a struggling economy and limited market access. Moody’s and Fitch Ratings followed with cuts to junk.

The Government Development Bank, which handles Puerto Rico’s debt transactions, said last week that it hired an affiliate of Millstein & Co. as a financial adviser. Jim Millstein, the company’s chief executive officer, was the U.S. Treasury’s chief restructuring officer until March 2011, according to the firm’s website.

Constitution’s Call

Puerto Rico’s constitution mandates that general-fund revenue must repay general-obligation debt first before other expenses. That may not matter if the island’s finances deteriorate, said Chad Farrington, head of credit research in Boston at Columbia Management Investment Advisors, which oversees $30 billion of munis.

“If doesn’t mean a whole lot if they get into distress and the ability to repay is not there,” Farrington said.

Investors have been pricing in a possible restructuring. Interest rates on Puerto Rico’s shorter maturities exceed those on longer bonds, a sign of a distressed credit, said Vikram Rai, an analyst at Citigroup Inc. in New York.

An index of five-year commonwealth debt yields 9.46 percent, 1.5 percentage points more than on 30-year securities, data compiled by Bloomberg show.

Yield Shift

If Puerto Rico raises enough funds, the gap between maturities may change within three months, Rai said. Yields on shorter maturities may fall, in particular for two- to 10-year debt, Rai said.

The next landmark for the island’s financial progress may come next month, when Governor Alejandro Garcia Padilla is set to release a budget for the fiscal year beginning July 1.

He has said his budget wouldn’t use borrowing to fill deficits, a practice used in every spending plan since at least 2000. Yet he will need to address a projected funding gap of $1.5 billion, about 15 percent of the fiscal 2014 budget, according to bond documents.

The sale is still attracting hedge funds and investors who typically buy taxable securities, such as corporate bonds.

Gregory Hanley, managing principal at New York-based Stone Lion Capital Partners LP, said Puerto Rico’s offer is “well oversubscribed,” meaning investors have submitted more bids than bonds available.

The hedge fund, which oversees about $1.5 billion, placed an order, Hanley said. Demand is being fueled by the yield levels and because the borrowing gives the island time to repair its finances, he said.

‘Cheapest Thing’

For investors in the highest tax bracket, an 8.73 yield sale is equivalent to 14.5 percent on a taxable basis. Similarly rated corporate debt yields about 4.8 percent, according to a Bank of America Merrill Lynch index.

“It’s just the cheapest thing out there by far,” Nuveen’s Miller said. “The underwriters and Wall Street firms that trade the securities in the secondary market have put a lot of effort into expanding the marketplace for the securities across global capital markets.”

With the anticipated downgrade to junk out of the way, demand for the island’s debt has soared. Puerto Rico securities have gained 10.1 percent in 2014, according to S&P Dow Jones Indices. The broader market has advanced 3.1 percent.

Puerto Rico general obligations maturing in July 2041 traded today with an average yield of 7.4 percent, the lowest since August.

“It’s getting demand and everyone’s been waiting for a while for them to do this,” said Daniel Solender, director of munis at Jersey City, New Jersey-based Lord Abbett & Co., which oversees $15.5 billion of local debt. “It will be a big obstacle out of the way if they can get it done.”

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