Muni-Bond Vultures Rethink Risks Lurking in Market's Junk YardBy and
Puerto Rico bankruptcy rule changes surprised traders
Distressed funds say they’ll demand discounts in the future
Puerto Rico’s bankruptcy has left distressed municipal-debt traders like Hector Negroni wondering if the old rules still apply -- not just in San Juan, but across the U.S.
The island’s effort to shred protections written into its constitution to determine which creditors get paid first has made Negroni reconsider the high-yield, high-risk corner of the $3.8 trillion muni-bond market. “They’re attempting to suspend the constitution,” said Negroni, a principal at New York-based hedge fund Fundamental Credit Opportunities and a member of the general-obligation ad hoc group pushing for full payback.
It’s true that no state has defaulted since Arkansas in 1933 -- Puerto Rico is a U.S. territory -- and that so far the island’s actions have had no evident effect on the broader muni bond market. But the reverberations could, eventually, reach highly indebted states like Illinois, New Jersey and Connecticut. Puerto Rico’s decision to renege on its constitutional commitment, the argument goes, may trigger a quicker deterioration in investor confidence in the next borrower that gets itself into real trouble.
As part of Puerto Rico’s bankruptcy, made possible by an act of the U.S. Congress last year, a judge will now decide how investors will split repayments of $74 billion in bond debt, and Negroni and others will likely have to take less money than they were promised.
“People are going to start pricing in an increased probability of laws changing” by demanding discounts when they buy distressed debt, Negroni said.
Distressed muni-debt traders usually buy when the credit rating of a bond is downgraded to junk status. That’s when institutions, such as mutual funds, are forced to sell or otherwise long-term retail investors get spooked.
“Next time around, you bet that they’re going to be asking for lower prices when mutual funds want to unload something like Illinois,” said Matt Fabian, a partner with Municipal Market Analytics Inc. in Concord, Massachusetts.
When faced with a swelling budget shortfall or a looming default, states are expected to do anything from raising taxes, cutting services or selling off assets to pay creditors. They don’t have access to bankruptcy protection. Neither did Puerto Rico until last year, when Congress voted to help the commonwealth restructure its unsustainable debt. Puerto Rico has said it can only cover about $8 billion of $33.4 billion in bond payments due through 2026.
The law change came as a shock to some general-obligation bondholders, such as Negroni, who believed they were doubly protected. Not only would there be no bankruptcy, but the commonwealth’s constitution said that repaying bondholders was a priority, even ahead of providing citizens with essential services. (That approach may not have thrilled those outside observers worried about worsening living conditions on the island, but it was the law.)
Although there’s been no decision yet on how bondholders will divvy up the money, hedge funds holding $1.4 billion of the general-obligation bonds, including Aurelius Capital Management and Monarch Alternative Capital, have already sued to receive overdue principal and interest payments.
Puerto Rico’s bankruptcy is the biggest in muni land. About half the states prohibit towns and cities from filing. Michigan isn’t one of them. In Detroit, which was the second-largest muni bankruptcy, bondholders didn’t do as well as they could have. Pensioners, despite not having first-paid status, were one of the least-impaired creditors, walking away with 82 cents on the dollar. General-obligation bondholders got 73 cents, and some water-and-sewer bondholders received as little as 1 cent on the dollar.
“You should know on the front end that laws can change, and that includes bailout packages as well,” said Jon Schotz, co-managing partner at Saybrook Fund Advisors, a $250 million private equity firm that invests in distressed and defaulted municipal securities, including Prepa, Puerto Rico’s public power utility.
Puerto Rico probably won’t be the last U.S. entity to change the rules to cut down on its debt, said Kjerstin Hatch, managing principal of Lapis Advisers, which has about $380 million in assets under management but no Puerto Rico.
“How the country will deal with municipal default is likely in its infancy,” Hatch said. “Ideas are forming, from a legislative and judicial standpoint, as to how we’ll handle large insolvent municipal entities.”
The flouting of constitutional rules may cause distressed muni-bond investors to insist on discounts, but it won’t scare them away from the market, Fabian said.
“The ending of this movie might disappoint them, but they’d buy the ticket to watch it again.”