March 24 (Bloomberg) -- Puerto Rico’s record $3.5 billion debt sale was structured to keep out individual investors with less than $100,000 to spend. Those buyers have found a way in, lured by the biggest rally in high-yield municipal bonds in five years.
The U.S. territory sold the securities March 11, in the largest junk deal ever for the $3.7 trillion municipal market. The borrowing came the month after the island was cut to speculative grade, and gave officials enough cash to pay bills through June 2015 as they try to revive a shrinking economy. Most of the original purchasers were hedge funds, and first-day trading in the bonds exceeded $5 billion.
Sale documents stipulate a $100,000 floor for purchases that also applies to trading after the securities price, said two people with knowledge of the sale who requested anonymity without authorization to speak publicly. Scores of transactions below that amount have been completed for the new debt, data compiled by Bloomberg show.
“These are intended for institutional purchasers, or at least for people that can afford the risk by making it a minimum denomination of $100,000,” said Martha Haines, who led the Securities and Exchange Commission’s Municipal Securities office from 2001 to 2011.
The investment floor is intended to limit holders to professional buyers, who typically have analysts reviewing credit risk, said Haines, who teaches municipal finance at the Maurer School of Law at Indiana University in Bloomington.
Asked about whether the Financial Industry Regulatory Authority was looking into the smaller trades, spokesman George Smaragdis said March 21 in an e-mail that the independent monitor of the securities business was “aware of the situation and is examining trading activity” in the bonds. Finra is based in Washington.
Investors are buying junk-rated munis for their higher yields as a growing U.S. economy boosts confidence the debt will be repaid. High-yield issuers are rated below Baa3 by Moody’s Investors Service and lower than BBB- at Standard & Poor’s.
State and city debt with such ratings has earned 5.8 percent this year, the best annual start since 2009, and surpassing the 3.2 percent gain for the broader municipal market, S&P Dow Jones Indices show.
Puerto Rico debt, which like that of other U.S. territories is tax-exempt nationwide, is leading the high-yield muni charge. It’s earning about 7.6 percent this year. The securities the Caribbean island sold this month mature in July 2035 and priced to yield about 8.73 percent, or 93 cents on the dollar. They have traded daily at an average above 8.3 percent, data compiled by Bloomberg show.
For earners in the top federal tax bracket, that’s equivalent to a taxable 13.7 percent, Bloomberg data show. Treasuries with a similar maturity yield about 3.4 percent.
“You’re really getting a lot of bang for your buck in owning munis that are cheap on an absolute basis,” said Mark Paris, who helps manage Invesco Ltd.’s $6.1 billion High Yield Municipal Fund in New York. “Then you get the tax exemption and that’s going to continue to keep the demand strong.”
Investors started trading the new Puerto Rico bonds the afternoon of March 11, with $5.1 billion changing hands, or 33 percent of that day’s volume for all local debt, according to the Municipal Securities Rulemaking Board, a self-regulatory organization that monitors the market.
The bonds gained as much as 7.5 percent after their initial pricing, reaching as high as 100 cents on the dollar on a $25,000 transaction at 10:47 a.m. in New York on March 12.
Sale documents say that “the bonds shall be issued in the minimum denomination of $100,000 and any integral multiple of $5,000 in excess thereof,” unless one of the three largest credit rating firms raise Puerto Rico’s score to investment grade.
Yet the securities have changed hands in at least 75 transactions below $100,000, according to data compiled by Bloomberg.
Trades below the minimum amount for investors that don’t already own at least $100,000 of the debt are a violation of MSRB’s Rule G-15 subsection F, Haines said. The rule states that brokers and dealers cannot execute trades of a municipal security that’s below the minimum denomination of the issue, according to the MSRB’s website.
“They can’t just do the smaller trade,” she said. “It has to be a minimum of $100,000 unless you have a customer who already has a $100,000 amount.
The SEC or Finra has the ability to enforce MSRB’s rules, Haines said. Depending on the level of violation, penalties may include fines, censuring brokers and dealers, or requiring new trading procedures to stop future violations, Haines said.
Jennifer Galloway, an MSRB spokeswoman, declined to comment about the Puerto Rico securities.
‘‘An issuer may feel that due to the risk of default, lack of publicly disseminated disclosure or other concerns, that the securities may not be appropriate for those retail investors who would likely purchase amounts below the minimum denomination,’’ Lynnette Kelly, MSRB’s executive director, said in an e-mailed statement.
‘‘The MSRB regularly makes referrals to the appropriate enforcement agencies when we become aware of possible rule violations,’’ she said.
The bonds declined on March 21. Their average yield was about 8.73 percent, the highest since they were free to trade, Bloomberg data show. The price touched as low as 92 cents, the cheapest yet.
The Bond Buyer reported March 19 that smaller-denomination sales were being made in violation of the requirement.
Puerto Rico has borrowed every year since at least 2000 to balance its operating budget, though Governor Alejandro Garcia Padilla has said his next spending plan will avoid the practice.
The self-governing island’s lawmakers have reduced pension benefits, raised taxes and shrank budget gaps to mend the territory’s finances.
The commonwealth and its agencies have $72 billion of debt and its economy has contracted 14 percent since 2006. Its 15.2 percent January unemployment rate was more than double the national average.
S&P on Feb. 4 cut Puerto Rico’s rating to one level below investment grade, citing the commonwealth’s economy and its lack of liquidity. Moody’s and Fitch Ratings followed with ratings one step below S&P’s.
The finances of the commonwealth of 3.6 million people influence the entire municipal market because about 70 percent of U.S. mutual funds that focus on local debt hold the securities, according to Morningstar Inc.
Given the commonwealth’s challenges, the debt should be held by investors who are aware of the possibility of default, said Sean Carney, a municipal strategist for New York-based BlackRock Inc., the world’s largest asset manager.
‘‘It’s irresponsible,” Carney said about trades below $100,000. “It’s not what the deal was meant to do -- to keep the risk with those who understand it.”
John Nester, a spokesman at the SEC, declined to comment.
Barbara Morgan, spokeswoman for Puerto Rico’s Government Development Bank, which handles the island’s debt sales, declined to comment. Lourdes Brezo-Martinez, a spokeswoman at Greenberg Traurig LLP, bond counsel for Puerto Rico’s borrowing, declined to comment beyond the sale documents.
Barclays Plc, Morgan Stanley and RBC Capital Markets served as underwriters on the deal.
Brandon Ashcraft, a spokesman in New York for Barclays, and Lauren Bellmare, a spokeswoman at New York-based Morgan Stanley, declined to comment. Sanam Heidary and Lauren Hopkinson, spokeswomen at RBC, a unit of Toronto-based Royal Bank of Canada, didn’t have an immediate comment on the Puerto Rico trades.
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