Puerto Rico Luring Hedge Funds on Record Price Drop: Muni Credit

Hedge funds and investors in distressed municipal debt are buying into Puerto Rico after prices on the territory’s securities set record lows on concern that its electric utility will restructure its bonds.

As the U.S. territory lurches toward crisis, buyers of risky debt see opportunity, said David Tawil, co-founder of hedge fund Maglan Capital LP, which bought island general obligations this week. The demand may help stem losses in Puerto Rico securities after they posted the biggest weekly drop since at least 1999.

The restructuring speculation is “knocking the daylights out of the rest of the commonwealth’s debt,” said Tawil, who oversees a $75 million fund in New York. “I don’t think that that’s a justified relationship.”

The Caribbean commonwealth’s general obligations and sales-tax debt, called Cofina bonds, sank after lawmakers last month approved a bill enabling certain public corporations to reduce their debt load outside of bankruptcy. Puerto Rico and the Cofinas had their ratings cut deeper into junk this month, further depressing valuations.

Crucial Appetite

Hedge funds’ appetite for Puerto Rico bonds has proven crucial this year. The funds and distressed buyers bought most of the island’s $3.5 billion junk-rated general-obligation deal in March, the biggest ever for the municipal market. The financing gave the self-governing island breathing room through at least mid-2015 as officials struggle to turn around a shrinking economy.

The buyers have picked up some slack from the typical holders of Puerto Rico bonds in the $3.7 trillion municipal market -- individual investors and mutual funds who favored the securities because they are tax-free nationwide.

Commonwealth general obligations and Cofina bonds may gain once investors become more comfortable with a potential restructuring, said Eli Combs, president of Greenwich, Connecticut-based MeehanCombs LP, a hedge fund that oversees about $300 million. He declined to say whether his company has been buying.

“There’s fear that’s been injected by this change in the law,” Combs said. “The reality, from our perspective as distressed-debt investors, is that the market tends to panic and then it tends to forget.”

Access Doubts

Peter Hayes, head of munis at New York-based BlackRock Inc., the world’s biggest asset manager, said last week that the downgrades and the new law have cost Puerto Rico access to traditional muni investors.

While the entire municipal market has gained 5.5 percent this year, debt of Puerto Rico and its issuers are little changed, S&P Dow Jones Indices show. Last week’s 6.4 percent tumble was the steepest since the data began in 1999.

Investors pulled $790 million from muni mutual funds in the past week, the most since January, Lipper US Fund Flows data show.

Governor Alejandro Garcia Padilla enacted the debt-restructuring bill June 28. It was the latest step to invigorate an economy that has shrunk about 11 percent since 2006, according to data from the Planning Board. Puerto Rico and its agencies have racked up $73 billion of debt, some of which helped paper over multiyear budget deficits.

The island collected $488 million less revenue than projected in the fiscal year that ended June 30 as corporate tax receipts were below estimates, according to preliminary data Puerto Rico’s Treasury Department released today. Officials cut $525 million of spending to compensate.

Upside View

Not all traditional municipal investors are abandoning the island. OppenheimerFunds Inc. says it’s betting Puerto Rico bonds will advance.

“The distressed securities have far more upside than downside in the long term,” the firm’s Rochester team wrote on its website last week. OppenheimerFunds holds the most Puerto Rico debt among U.S. mutual funds, according to Morningstar Inc.

Puerto Rico general obligations maturing in July 2035 and originally sold at 93 cents on the dollar in March traded at an average price of about 84.39 cents on July 3, the lowest ever, data compiled by Bloomberg show. The bonds yielded 9.76 percent, equivalent to a 16 percent taxable rate for top earners.

Rating Cuts

Moody’s Investors Service July 1 cut $14.4 billion of Puerto Rico general obligations to B2, its fifth-highest speculative grade. Fitch Ratings this week dropped the debt to BB-, its third-highest junk rating. Standard & Poor’s also grades the obligations junk.

Moody’s and Fitch this month also dropped the sales-tax bonds to junk, stripping Puerto Rico of the ability to borrow at investment-grade rates.

Puerto Rico Electric Power Authority, the island’s electric utility, is a prime candidate for restructuring. It tapped $41.6 million of reserves to help make a July 1 payment to bondholders, according to a notice filed yesterday on the Municipal Securities Rulemaking Board’s Electronic Municipal Market Access website.

S&P this week downgraded the agency to B-, its sixth-highest junk rating. The provider faces $671 million of bank lines of credit due by mid-August that it doesn’t have sufficient funds to repay, Judith Waite, an S&P analyst, wrote in a July 9 report.

Fiscal Retooling

David Chafey, chairman of the Government Development Bank, which handles the commonwealth’s debt sales, and Treasury Secretary Melba Acosta said this week that even if a Puerto Rico agency were to use the new law to negotiate with bondholders, its general obligations, Cofinas and other direct obligations are excluded.

The law may help public corporations retool their finances and operate without subsidies from Puerto Rico’s operating budget, Chafey and Acosta said in an e-mailed statement. The administration has reduced budget deficits and increased sales-tax collections, which should boost confidence that Puerto Rico will repay its direct debts, they said.

“Puerto Rico has repeatedly delivered on its credit promises and the willingness and ability of the commonwealth to honor its obligations should be unquestioned in light of its actions over the last 18 months,” Chafey and Acosta said yesterday in an e-mailed statement.

If Puerto Rico can reduce its debt and public agencies are able to operate without commonwealth assistance, that will strengthen the general obligations and sales-tax debt, Combs and Tawil said.

“Everyone’s hunting for opportunities,” Tawil said. “It should attract a considerable amount of attention.”

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