Puerto Rico's planned debt issue may still find demand among mutual funds after the commonwealth was cut to junk grade by Standard & Poor's, even though some fund managers are restricted from buying speculative paper.
Eric Jacobson, an analyst at Morningstar Inc., said most mutual fund managers who own the now-downgraded Puerto Rico general obligations can continue to hold the speculative-grade securities and are not required to sell the bonds. However, he said their future exposure to the debt could be limited.
"The same funds may not be allowed to buy bonds when they're rated below investment grade, but they're typically not forced to sell," Jacobson added.
"The governing logic is typically that the funds may have a reasonable chance at recovering some value if the affected credit improves, which would be preferable to selling at a deeper loss. In cases of default, for example, a fund may also have a better shot at a meaningful recovery as a result of a work out or even the distribution of assets in the case of a bankruptcy."
S&P turned up the heat on the island's financial distress when it downgraded $31.6 billion of its general obligations and other debt to junk level late Tuesday, leading to confusion and uncertainty among market participants about whether managers of high-grade funds would be required to dump existing holdings, and whether demand for the planned issue would be hurt.
About 70% of mutual funds hold Puerto Rico bonds, which offer exemption from state, local and federal taxes.
Hugh McGuirk, head of municipals at T. Rowe Price, said although every fund complex has different rules and regulations, most have some wiggle room, even with respect to junk holdings.
"There's definitely capacity," he said. "It's a matter of whether there's willingness — that's the $2 billion or $2.5 billion question," referring to the rumored size of the commonwealth's pending sale.
McGuirk said he has the ability to own below investment-grade bonds in all of the firm's municipal funds, which total nearly $20 billion. He said he will continue to keep Puerto Rico issues on his radar screen, despite S&P's action. "I can't imagine too many institutional buyers who will have the switch flipped off because of S&P's action in and of itself," he said. "If we found it compelling enough we would be free to participate," he said of new Puerto Rico issuance.
"Right now, we are in a wait-and-see mode on Puerto Rico," McGuirk said. "Most fund managers are sophisticated buyers and realize prior to the downgrade that Puerto Rico was trading below investment-grade already."
The commonwealth's triple-exempt paper is considered universally acceptable and the debt is widely held by both national funds and state-specific funds, which buy the bonds as a substitute in times of supply shortages in their respective states. Others said fund managers may be weighing options.
"Many funds have loopholes in their prospectuses that may allow them to continue to hold bonds that have been downgraded to junk, particularly to avoid forced selling into unfavorable market conditions," said Triet Nguyen, managing partner at Axios Advisors LLC, an independent municipal research and investment advisory boutique.
"Others can hold bonds that are split-rated between junk and investment grade, so they may only need one out of the three rating agencies to maintain an investment- grade rating," he explained. "Still others have had plenty of time to ask their Board of Trustees for special permission to hold the debt in order to avoid a fire sale."
John Mousseau, director of fixed income at Cumberland Advisors, said while funds differ in their treatment of junk bonds, he expects the new deal could get done, particularly with added support from hedge funds, even at double-digit yields. "I think especially if you are getting a third lien on sales tax, I think they will have a food fight on their hands, he said. "Some funds must sell if their bonds are below investment grade, and some may not have to sell it until Moody's [Investors Service] downgrades."
Analysts expect it won't be long before that occurs, and said investors could be waiting to see if the governor makes good on his promises of fiscal recovery.
The relatively few Puerto Rico bonds that appeared on bid-wanted lists as well as the light secondary trading of the island debt earlier this week was evidence that large institutional funds that still own any P.R. GOs are holding onto them, at least for now, muni traders said.
Franklin Double Tax-Free Income Fund (A Shares); the Oppenheimer Rochester Maryland Municipal Fund (A Shares); and the Oppenheimer Rochester Virginia Municipal (A Shares), are the top three fund holders of Puerto Rico debt, according to newly revised data from Morningstar Inc. Peter Hayes, head of the municipal bond group at BlackRock Inc., said in a blog post Wednesday he expects minimal downgrade-related ripple effects, largely because the downgrade was already priced into the market. Many funds managers sold island debt last year when prices plummeted and yields surged to more than 10% due to the commonwealth's financial shortfalls, analysts have said.
Those investors took notice when the broader market was down 2.55% and the Puerto Rico market was down 20.47%, Hayes noted.
Nguyen suggests most of the forced selling could be over. "Much of the systemic risk related to P.R. may already have occurred," he said, citing the massive mutual fund liquidations the market endured over 33 consecutive weeks in 2013, "particularly out of those institutions that were over-weighted in P.R .paper."
David Tawil, co-founder and portfolio manager at Maglan Capital in N.Y., who manages a $60 million hedge fund, said negative headlines may convince some fund managers to sell the junked debt, but he is eagerly awaiting additional headline risk that will push prices even lower.
"I'm long-term bullish and I want to buy the debt as cheap as possible to make the great gains," Tawil added, noting that the commonwealth is at the mercy of the market when it comes to its reported $2 billion deal. "They are in a precarious situation now. So it's almost imperative that deals get done."
Other market participants continue to debate life for Puerto Rico after the downgrade.
"The [rating] action doesn't seem to signify further credit deterioration - although the very action creates more headwinds for Puerto Rico to navigate," said Marie Autphenne, director of fixed income research and strategy at Stifel Nicolaus & Co..
"I think it raises the bar in terms of the immediacy in which the federal government has to address things," Mousseau of Cumberland said.
"It's a terrible stain on the United States to have a territory even approach default," he said.
S&P Dow Jones last month removed all U.S. territories, including Puerto Rico, from its investment-grade indexes, indicating they no longer meet the established objectives.
