Puerto Rico Lures Hedge Funds for Record Junk Deal: Muni Credit
Puerto Rico’s record $3.5 billion sale of junk-rated municipal debt buys the struggling U.S. territory at least 15 months of financial breathing room. It took demand from hedge funds to get the deal done.
The issue gives the island, which was cut to junk last month, enough cash to pay bills through June 2015, as officials try to turn around a shrinking economy. The tax-exempt debt matures in July 2035 and was priced to yield about 8.73 percent, data compiled by Bloomberg show. Leading up to the sale, investors speculated yields could exceed 10 percent. It still eclipses the 4.8 percent level on similarly rated company debt, according to Bank of America Merrill Lynch data.
The self-governing commonwealth received orders for about $16 billion of bonds, according to the island’s Government Development Bank. The majority of buyers were hedge funds, although traditional muni investors participated, David Chafey, chairman of the bank, said in an interview. The deal is the largest-ever junk-rated offer for the $3.7 trillion municipal market.
“The good news is that we’ve been able to attract a broader level of investor, but the bad news is we did have to go to those other investors in order to get the deal done,” said Tom Spalding, senior investment officer at Chicago-based Nuveen Investments Inc., which manages about $90 billion of munis. “So longer term, are they going to be there to support our market?”
The finances of the commonwealth of 3.6 million people influence the entire municipal-bond market because 70 percent of U.S. mutual funds that focus on local debt hold the securities, according to Morningstar Inc. The island’s bonds, like territories such as Guam, are tax-exempt nationwide.
Puerto Rico sold into a rally. Its debt is off to its best annual start since 1999, gaining about 10 percent this year, according to S&P Dow Jones Indices. The entire municipal market has earned about 3.1 percent.
The advance gained momentum after Standard & Poor’s lowered the island to speculative grade on Feb. 4, citing limited access to capital markets and a contracting economy. Puerto Rico’s jobless rate was 15.4 percent in December, more than double the U.S. average.
Moody’s Investors Service and Fitch Ratings followed with cuts to junk, freeing up purchasers who had been holding off for months as they waited for the downgrades.
Yesterday’s borrowing allows Puerto Rico to refinance debt, balance budgets and repay the GDB, adding $1.9 billion to the bank’s liquidity, according to the bank, which handles the island’s debt transactions.
Barclays Plc (BARC) led banks receiving orders from about 270 investors, according to the GDB.
“Hedge funds did provide quite a bit of liquidity,” Chafey said. “It certainly gives us time to continue working on the measures that we’ve committed to do in terms of balancing the budget.”
Even with the demand from different types of buyers, Puerto Rico won’t borrow again through June, Chafey said. The commonwealth may sell sales-tax bonds later this year or in 2015, he said.
The new bonds gained in initial trading. They exchanged hands at an average yield of about 8.33 percent as of about 10 a.m. in New York, data compiled by Bloomberg show.
At the same time, yields on bonds the island sold in 2012 fell to the lowest since August.
Given the excess orders, some investors will sell to capture the early gains, said Gregory Hanley, managing principal at New York-based Stone Lion Capital Partners LP. The hedge fund oversees $1.5 billion and placed an order on the sale.
“You may see some people try to trade out of them if they rally dramatically, but our intention is to hold this as an investment,” Hanley said before the bonds were priced.
Puerto Rico lawmakers have reduced pension benefits, increased taxes and trimmed budget gaps to mend the island’s finances. The commonwealth’s next hurdle is to balance a budget for the fiscal year beginning July 1 that doesn’t rely on deficit financing, a practice used in every spending plan since at least 2000.
Governor Alejandro Garcia Padilla is set to release the plan next month. 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.
“This budget is different from last year,” Treasury Secretary Melba Acosta said in an interview. “It’s not going to be so much about revenue measures, but about expense reduction.”
The new bonds are callable in July 2020, which may make it easier for Puerto Rico to refinance should interest rates be lower in the future.
To help lure buyers, the commonwealth agreed to give investors the ability to sue in a New York court, a first for Puerto Rico general obligations, in the event of a default on this deal, according to bond documents.
The GDB also 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.
The move “should provide the market comfort that we’ve hired teams of that caliber,” Chafey said in an interview on CNBC after the sale yesterday.
Puerto Rico’s deal surpassed a $1.2 billion junk-rated muni borrowing from the Iowa Finance Authority last year for a fertilizer plant.
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