Puerto Rico: Small tropical island, giant muni bond debt

Puerto Rico’s municipal debt market is in a precarious state

The precarious state of Puerto Rico’s municipal debt market has come into focus after William Galvin, Massachusetts secretary of the commonwealth, launched an investigation into sales of the US territory’s bonds by leading mutual fund managers to residents of his state.

Puerto Rico’s reputation as a bond issuer, with more than $70bn of outstanding debt, has taken a beating amid concerns about the ability of politicians to balance the island’s budget and its 13.9 per cent unemployment rate.

“It’s a bad situation in Puerto Rico and I don’t know how they can get themselves out of it,” says Stephen Winterstein, managing director and chief strategist for municipal fixed income at Wilmington Trust Investment Advisors.

It remains uncertain whether politicians and regulators in other states will follow Mr Galvin and open secondary fronts in the war against local fund houses that offer muni bond funds with exposure to the Puerto Rican debt market.

However, it may well be that Mr Galvin’s efforts to battle on behalf of investors triggers a wave of class action lawsuits as well as further selling of Puerto Rico’s bonds.

The sell-off in the territory’s debt, which started in August, persists in the retail market. Hedge funds and managers of distressed assets, however, are said to be picking up debt sold by Puerto Rico. They are betting that prices are low enough that they will profit if the island either recovers from recession or restructures its bond holdings.

As FTfm went to press, the average yield investors demand to hold 30-year Puerto Rican debt hovered at 8.56 per cent, a near-record high and comfortably above the 5.58 per cent yield at the turn of the year, according to data from Thomson Reuters MMD.

Yields on 10-year debt have also risen sharply to 8.65 per cent, up from 4.62 per cent in January.

A number of fund houses in Massachusetts and elsewhere run municipal bond funds that invest primarily in debt issued by individual states. But it is less well advertised that a number of these funds also invest in Puerto Rican muni bonds.

Investors’ interest in Puerto Rico’s debt stems from the special tax breaks it attracts. Puerto Rican bonds are exempt from federal, state and local taxes regardless of the state the bondholder resides in, making them a ubiquitous feature in muni bond portfolios.

Massachusetts has sent letters to UBS, Oppenheimer Funds and Fidelity requesting information on how their municipal funds that contained Puerto Rican municipal debt were sold to the state’s residents.

Oppenheimer, which is co-operating fully with Mr Galvin’s investigation, has the largest exposure to Puerto Rican debt. Other big houses with funds bearing some exposure include Wells Fargo, Franklin Templeton, Putnam, MFS, John Hancock and BlackRock.

Out of 569 muni bond mutual funds tracked by Morningstar, the data provider, 49 have an exposure to Puerto Rican debt of at least 10 per cent.

Alerting the public to the investigation, which will also review whether these bonds have been properly priced since July 2012, Mr Galvin warned: “Puerto Rico is currently on the verge of insolvency and many of its obligations are at or near junk rating, thus the risks associated with its municipal debt obligation are disproportionally high.”

He continued: “Many mutual funds have liquidated some or all of their Puerto Rico holdings, which could have a detrimental monetary impact on the funds as well as to further drive down bond prices.”

The uncertainty surrounding Puerto Rico’s muni market is likely to persist for some time, analysts say. Before the sell-off, Puerto Rican debt was not traded “very actively”, Mikhail Foux, Vikram Rai and George Friedlander, muni bond analysts at Citi, said in a recent report.

But the trading dynamics have changed radically since August, according to Citi. Monthly trading volumes jumped from $3bn-$5bn to more than $20bn. This is equivalent to about 8.5 per cent of the volume of trading in the secondary municipal bond market, which is $4tn in size.

The island’s debt levels remain far higher than any US state. Net tax-supported debt stands at more than $14,000 per capita, 89 per cent of Puerto Ricans’ personal incomes.

Puerto Rico’s general obligation bonds only have a Baa3 rating from Moody’s and a BBB- rating from Standard & Poor’s, the lowest investment-grade ratings the agencies give. Both rating agencies also maintain a negative outlook on the debt. They cite the refinancing risks brought about by Puerto Rico favouring short-term financing instead of planned long-term financing due to the persistence of volatile market conditions.

“Debt levels are very high and continue to grow,” wrote Moody’s analysts this month when they kept the territory’s rating at Baa3. “Financial performance has been weak, including structural budget gaps that have led to a persistent reliance on deficit financings and serial debt restructurings to support operations in recent years.”

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