Hedge funds and cross-over investors are expected to devour Puerto Rico's junk-rated sale of general obligation bonds when the $3 billion deal thunders into the primary market on Tuesday.
Traditional municipal investors, municipal observers said, will take a back seat in the market for the Puerto Rico credit, which was considered a staple investment for them when the commonwealth was still investment grade.
Puerto Rico's first sale of GOs in two years may benefit from low supply and improving demand for tax exempt debt, particularly among high-yield investors. The deal highlights an $11 billion surge in new issuance planned for the week, after February muni volume plunged to the lowest level in 14 years.
"Municipal bonds have enjoyed a strong start to the year and broader market yields are near a nine-month low, which helps the Puerto Rico deal," Anthony Valeri, market strategist at LPL Financial Valeri, said in an email. "The lowest new issuance pace in many years may also help boost demand for this issue."
Hedge funds, cross-over buyers, and other aggressive investors are salivating at the possibility of taxable-equivalent yields at or near 10%, analysts said, even with the risks implied by the junk ratings.
Demand from these non-traditional buyers will be so strong, they will dictate the pricing and dominate the sale, experts said.
"Hedge funds are going to drive a hard bargain here," said Dan Heckman, senior fixed-income strategist at U.S. Bank Wealth Management.
Barclays Capital is senior manager and Morgan Stanley and RBC Capital Markets will be joint lead managers for the sale. The bonds have a term maturity in 2035, but will mature according to the sinking funds schedule from 2022 to 2035, according to a source close to the deal. The bonds will be callable at par, though the call date wasn't announced.
Proceeds will largely repay outstanding debt and help strengthen the commonwealth's fiscal position after it was downgraded to junk by all three major rating agencies earlier this year.
Heckman said "high 8% and low 9% yields" are likely for bonds maturing in 10 years and longer, and he wouldn't be surprised to see double-digit yields on the term bond.
Peter Hayes, managing director and head of the municipal group at BlackRock Inc., said hedge funds will demand "above and beyond market yields" - as close to double digits as possible.
"There is a real thirst for yield in this market," Heckman said. "It's going to gain the attention of the market next week. We don't think they would have brought it unless the underwriters have taken a temperature check on the appetite for this."
Many traditional fund managers, Heckman said, will be limited by the criteria that governs their credit selection process, now that the bonds are rated below investment grade, at Ba2 by Moody's Investors Service, BB-plus by Standard & Poor's and BB by Fitch Ratings. The agencies cut their ratings earlier this year citing concerns over the commonwealth's ability to tap the capital market for liquidity.
"There is a narrow scope of who can actually come in and buy the deal from a credit rating standpoint," Heckman said. "There may be a few traditional mutual fund managers, but very few in that category," he predicted.
"Many retail shops have limited their participation in Puerto Rico bonds due to the downgrades, price volatility, and liquidity issues," added Patrick Early, chief municipal analyst at Wells Fargo Advisors.
The debt has historically been widely-accepted because of its exemption from state, local, and federal taxes. About 70% of mutual funds hold Puerto Rico bonds, though many fund managers sold island debt last year when prices plummeted and yields surged to more than 10% amid concern over the commonwealth's debt load and the persistent recession in the island's economy.
S&P Dow Jones in January removed all U.S. territories, including Puerto Rico, from its investment-grade indexes, indicating they no longer meet the established objectives.
On the other hand, the new deal is an opportunity for an attractive risk-to-reward bet for sophisticated and aggressive buyers, analysts said. The preliminary official statement for the offering devotes 14 pages to the "significant risks" associated with the bonds, including "price declines, limited liquidity, and the possible failure to pay debt service."
The bonds also have no collateral and cannot be accelerated upon default, according to the POS.
Taxable high-yield fund managers will be interested in the possibility for credit recovery in the event there is a restructuring, Heckman said.
The availability of compelling yields in the absence of other attractive fixed-income opportunities should also lure savvier investors, LPL's Valeri said.
He noted that taxable high-yield bond spreads hit a post-recession low this week, while the average yield of high-yield bonds is hovering just above 5% -- which is also near a post-recession low.
"In that context, double-digit, taxable-equivalent yields for the proposed new issue, and outstanding bonds, look attractive," Valeri said.
The bonds should also be attractive versus other municipal high yield bonds. "Existing P.R. debt yields 0.5% to 1.5% more, on average, than the average municipal high-yield bond, so the new P.R. issue is likely to stand out," Valeri said.
The deal's timing comes amid historically-low volume in the primary market, favorable market conditions, and as yields on Puerto Rico bonds in the secondary have rallied to six-month lows. Its arrival will boost volume to an estimated $11.12 billion next week, according to Ipreo LLC and The Bond Buyer, from just $3.5 billion last week, according to Thomson Reuters.
"It is a very large deal when you think about the calendar, which has been very, very small, so this will be everyone's focus for the next week or week and a half," Hayes said.
Amid the focus on Puerto Rico, California is planning to sell $1.6 billion of GO debt on Thursday after a two-day retail order period in a new-money and refunding deal jointly managed by Bank of America-Merrill Lynch and RBC Capital Markets. Those bonds are rated A1 by Moody's and A by Fitch, while Standard & Poor's assigns an A rating to outstanding GOs.
The jump in issuance comes after February volume was the lowest since 2000, according to data from Thomson. Total year-to-date issuance is the second-lowest in 10 years, according to Bloomberg data.
On Wednesday the average yield on the most actively-traded Puerto Rico commonwealth GO bonds with a 5% coupon maturing in 2041, as well as those with a 5.5% coupon in 2039, fell to 7.53% and 7.73%, respectively, their lowest since August.
"It's a big deal in the market and we are going to follow it and make a credit determination," Hayes of BlackRock said late Wednesday.
Hayes said a special liquidity update from the Government Development Bank for Puerto Rico should help "give investors who were on the fence more clarity of the financial situation."
The GDB, as part of its ongoing disclosure and transparency efforts, issued a press release late Wednesday directing investors to its website at www.bgfpr.com where they could access a brief overview of the GDB's liquidity position as of Jan. 31, 2014.
Meanwhile, the potential to earn yields that are twice as high as high-yield corporate bonds is sparking interest among hedge funds, high-yield municipal funds, and multi-asset fixed-income buyers, according to Eric Friedland, head of municipal research at Schroder's Investment Management.
"Demand for bonds right now is insatiable, especially for munis," he said.
In addition, Friedland said an unprecedented provision for the Puerto Rico GOs may heighten hedge fund demand.
Gov. Alejandro Garcia Padilla this week signed a bill stating that New York laws apply to the new GOs and they could be litigated in New York state and federal courts in New York City, rather than an island jurisdiction.
Some investors believe that in the case of a default, a New York court might render a more bond-holder friendly ruling than a Puerto Rico court would.
"To the extent the hedge fund buyers believe this actually could occur, these bond holders feel they have some sort of seniority over the other bondholders," Friedland said. "The buyers of these bonds are going to be hanging their hat on that."
The POS states, however, that New York courts may decline to hear the suit.
Friedland said the successful completion of the deal would have less impact on the overall municipal market than would a failed sale.
"If this deal doesn't succeed," he said, "the rating agencies would continue to downgrade the commonwealth and that would lead investors to believe there would be a credit event on the island."
