Puerto Rico Record Yields Luring Buyers of Distress: Muni Credit
Puerto Rico’s record-high yields are attracting investors who typically buy the riskiest municipal debt, in a sign of how dire the island’s finances have become as it prepares to borrow as much as $1.2 billion by year-end.
As the commonwealth’s leaders struggle to revive a shrinking economy and keep the territory’s debt above junk, yields have risen enough that hedge funds, which aren’t traditional municipal investors, have been buying, according to Matt Fabian at Municipal Market Advisors. Jon Schotz, who focuses on defaulted munis at Kayne Anderson Capital Advisors LP, which oversees about $23 billion, said he’s analyzing the island’s obligations for a possible purchase.
Puerto Rico, whose debt is tax-exempt nationwide, must borrow by Dec. 31 to balance its budget. Officials plan on using bonds backed by sales-tax revenue, as the securities are rated three to four levels above the island’s general obligations. Even the sales-tax securities, which Moody’s Investors Service cut yesterday, trade with historically high yields.
“It’s certainly more interesting than it was before,” said Schotz, a co-managing partner who oversees more than $300 million of distressed munis in Los Angeles. While “they’ve demonstrated willingness to pay over the years,” they will be challenged to find sufficient buyers going forward, he said.
A Puerto Rico general-obligation bond maturing in 2041 traded today with a yield as high as 10.06 percent, the most since Sept. 9, according to data compiled by Bloomberg.
“Forced selling in local island bond markets have added stress to overall trading, with nontraditional investors such as hedge funds entering the market at recently distressed prices,” Alan Schankel, managing director at Janney Montgomery Scott LLC in Philadelphia, said in a research note today. “Volatility and price pressures remain ongoing for Puerto Rico bonds.”
The new category of investors is buying as the commonwealth’s debt has lost about 17 percent in 2013, on pace for the worst year since at least 2000, according to Standard & Poor’s. Puerto Rico and its agencies have about $70 billion of debt, data from the island’s Government Development Bank show. National and state-specific mutual funds hold the securities for their tax benefits.
For Governor Alejandro Garcia Padilla, 42, who took office in January, the bond sell-off magnifies the challenge of a contracting economy. An index that measures the commonwealth’s economy fell 5.4 percent in August from a year earlier, the biggest decline since 2010, according to the development bank, which handles the island’s capital-market transactions.
More than $1 billion of the $9.77 billion budget for the fiscal year that began July 1 relies on new tax measures. So far, revenue is on track. The territory collected $968 million of net general-fund revenue in July and August, $12 million above budget, according to Treasury Secretary Melba Acosta.
Garcia Padilla, of the Popular Democratic Party, is tackling recurring budget shortfalls and has enacted laws boosting the retirement age and workers’ pension contributions. Puerto Rico’s pension system has a funding level below that of any U.S. state.
Moody’s affirmed the commonwealth’s Baa3 general-obligation rating yesterday, calling the administration’s fiscal steps “significant.” At the same time, it lowered $6.8 billion of sales-tax borrowings two steps to A2, sixth-highest, citing a weak economy.
“They’ve bought themselves a couple of years” with the pension and budget steps, Guy Davidson, who helps manage $31 billion as director of munis at AllianceBernstein LP in New York, said at an Oct. 1 media presentation. “But in the end they have to grow.”
The fiscal stress has made Puerto Rico the $3.7 trillion municipal market’s worst performer. Its 2013 loss is six times as steep as declines in the rest of the market.
Sales-tax bonds maturing August 2042 traded yesterday with an average yield of 7.5 percent, the highest ever, Bloomberg data show. The yield spread over benchmark munis was 3.3 percentage points, the most since July 29.
For investors in the highest income bracket, that’s a taxable-equivalent yield of about 12 percent.
“You can’t find anything for that type of credit in the taxable market that’s equivalent,” said Michael Walls, who helps manage $2 billion of high-yield munis at Waddell & Reed Financial Inc. (WDR), based in Overland Park, Kansas.
Lawmakers are working on legislation that would increase the percent of revenue directed to repay the island’s sales-tax bonds to 3.5 percent from 2.75 percent as part of the plan to refinance debt.
The plan to use sales-tax bonds “marks another step forward in Puerto Rico’s progress,” Acosta said yesterday in a statement.
“This administration has implemented a number of very significant measures to support sustainable economic growth through job creation and continued progress towards a balanced budget,” Acosta and Jose Pagan, the development bank’s interim president, said in a separate statement.
The declines in the debt may not be over. Yields may rise as much as another 2 percentage points on some bonds because of the island’s faltering economy and debt levels, said Peter Hayes, head of munis at New York-based BlackRock Inc., which oversees $109 billion of local debt.
“It’s a dire situation in terms of the amount of debt they have outstanding, the weakness in their economy,” Hayes said yesterday on Bloomberg Radio.
Demand from hedge funds and distressed-debt investors may help Puerto Rico because some high-yield muni buyers are limited in how much commonwealth debt they can hold. While Walls has been increasing holdings in the past month, he’d like to add more.
“We’ve seen opportunities,” Walls said. “Some we’ve taken advantage of and some we can’t take advantage of at these attractive yields as much as we would like to. I have to make sure I manage my cash for potential redemptions.”
Municipal interest rates have been little changed this week close to a three-month low as the partial shutdown of the nation’s government extended to a third day.
The ratio of the yields, a measure of relative value, is about 105 percent, compared with an average of 93 percent since 2001. The higher the figure, the cheaper munis are compared with federal securities.
Following is a pending sale:
The Texas Higher Education Coordinating Board is offering about $113.5 million in general-obligation debt to finance loans to college and university students, with pricing of the issue set for Oct. 8, according to Bloomberg data. The sale will be by competitive bid.
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