Burdened by a weak economy and dropping credit ratings, Puerto Rico issuers will have to rely on hedge funds and other non-traditional investors as they bring more than $3.5 billion of bonds to market in the coming months.
"I don't see a lot of traditional muni buyers participating at this stage," Triet Nguyen, managing director and co-head of municipal and corporate credit at financial advisory and consulting firm NewOak Capital LLC said in an interview last week. "They are appealing to a completely different audience."
Planned sales include a deal for as much as $2.95 billion from the Puerto Rico Infrastructure Finance Authority and of up to $700 million from the Puerto Rico Aqueduct and Sewer Authority. The legislature is contemplating a smaller sale of general obligation bonds as well.
The sales will further distance mom and pop retail investors from the debt they once coveted for its universal triple-tax exemption. The commonwealth was downgraded to junk in February 2014, and the official statement for its $3.5 billion GO sale the following month barred retail investors by forbidding trades under $100,000.
The percentage of municipal bond funds with exposure to Puerto Rico, which stood at about 69.26% in February, 2014, has fallen to 54.08%, as of Feb. 26, according to Morningstar Inc.
"It's going to be tough sledding to get much [demand] from the average investors," Rob Williams, managing director of fixed income and an analyst at Charles Schwab said in an interview last week.
"We are very cautious for the average investors to be looking at Puerto Rico debt," he said. "Given how much of a liquidity issue there is makes it a highly speculative credit."
Instead, the deals are likely to lure cross-over buyers, like hedge funds and other non-traditional investors, who try to manage the risk and boost returns on distressed securities through the use derivatives and other strategies.
David Millar, spokesman for the Government Development Bank, which handles Puerto Rico's debt sales, said on Wednesday it was still too early to comment on the pricing details and the expected market acceptance of the planned deals.
Analysts, meanwhile, said liquidity will be a major issue as the deals come to market amid restructuring negotiations between the Puerto Rico Electric Power Authority and its bondholders.
"Right now, between what's going on with PREPA and the necessity of doing the PRIFA deal, most market participants are very nervous," Nguyen said.
The pricing, structure, and spreads of the PRIFA deal, for instance, are crucial in securing the necessary participation from non-traditional buyers that the conduit and the island need to boost liquidity, according to Nguyen.
If liquidity suffers, it will damage the perception of the rest of the Puerto Rico debt complex, he said.
The PRIFA deal will have to come at steep discounts and coupons of 8.5%, Nguyen said.
Traditional mom and pop retail investors should be wary of the high coupons, expected double-digit yields, and wide spreads that could accompany the bonds, analysts said.
"Yield is still very hard to come by — certainly tax-exempt yield," Williams said. At the same time, he said, average, individual investors should limit their exposure to the commonwealth — especially during times of distress.
"The average investor would have to decide if 600 basis points is adequate compensation," Williams said, referring to the spread between Puerto Rico and triple-A municipal market yields. "It's a complex situation and we don't suggest Puerto Rico" for the traditional municipal bond investors, he added.
Others agreed that non-traditional investors will be the natural buyers.
"I assume that the lions' share of the anticipated deals will be allocated to hedge funds who are already familiar with the situation, are very heavily-aware of the financial circumstances, and are well-versed in the political issues," said David Tawil, president and portfolio manager at New York City-based hedge fund Maglan Capital.
Tawil, who only buys securities like Puerto Rico in the secondary market at a discount, said any new island deals should have no trouble being placed among yield-hungry cross-over players.
"I would assume that the proper profile would be a fund smart enough to understand the distress, but could also justify buying the new issue for high-yield return reasons," Tawil said.
"Although the coupon may be high and the [original issue discount] may be big, I don't think allocation will be a problem," given the size of the deals, he added.
Likewise, Nguyen expects mostly hedge funds, some insurance companies, and other cross-over buyers to participate in the PRIFA deal and build liquidity.
"If the GDB does not get the liquidity infusion it needs, the whole house of cards can come crumbling down," Nguyen said.
The government's efforts to ease its fiscal burdens are likely to go unnoticed by traditional municipal investors, given the weakness of the commonwealth's broader economy and uncertain direction of its credit forecast, the analysts said.
"The commonwealth's economy went into recession before the mainland and has really not evidenced any recovery, despite some hard improvements implemented as far as expenditure reduction," said Mark J. Tenenhaus, director of municipal research at Summit, N.J.-based asset management firm RSW Investments LLC and long-time municipal research analyst and strategist.
The islands ratings have continued to slide, as Fitch Ratings cut the commonwealth's general obligation debt to B from BB-minus in late March.
Fitch also downgraded PRASA'S senior lien revenue bonds to B from B-plus.
Tenenhaus, who said RSW doesn't buy Puerto Rico paper for the $2 billion of separately-managed municipal bond client accounts, predicted the Fitch downgrades will have little impact on the new deals, since traditional retail buyers are unlikely to participate.
Most analysts have viewed Puerto Rico as a speculative credit for some time, so the rating agencies are catching up to and reflecting what the market already knew, Williams said.
Meanwhile, the lack of long-term recovery solutions is also problematic for the commonwealth given its shortfalls in manufacturing, pension reform, and accounts receivable, among other deficiencies. That is adding to the already highly risky nature of its new bond sales, the analysts said.
"Despite any potential liquidity influx, the longer-term fundamental problems will remain difficult, if not even insurmountable, as recent history has shown," Tenenhaus said.
J.R. Rieger, global head of fixed income at S&P Dow Jones Indices, described Puerto Rico in a March 29 report as "an ugly and complex situation that is likely to lead to some massive defaults of Puerto Rico revenue bonds."
"State funds with Puerto Rico bond exposure are impacted on two fronts; bond prices falling and possible lack of liquidity — when and if they decide to sell the bonds," he wrote in the report entitled "The Rieger Report: 2015 Headwinds & Tailwinds for Municipal Bonds."
The recent drop in bond prices is helping to weigh the high yield segment down, Rieger said in his report.
The S&P Municipal Bond Puerto Rico Index has dropped 1.34% in March eroding the previous two months of positive performance, Rieger said.
There are no Puerto Rico bonds in the S&P National AMT-Free Municipal Bond Index, he said, though uninsured bonds are included in the S&P Municipal Bond High Yield Index.
While Williams said traditional investors may want to consider the insured portions of new Puerto Rico deals for the triple-exemption and potential yield, he said that could be a dangerous decision.
"Our recommendation is they should look more deeply — look at the speculative characteristics of the underlying credit," Williams said.
"None of our advisors will recommend it for individual clients," he said. "Many are still looking to learn more of what can happen to the bonds they hold, and whether those bonds are covered by insurance and if the insurance companies will continue to pay. We don't see as many clients interested if they see an upcoming transaction."
A wide range of retail investors, and municipal mutual funds, including high-yield funds, had bought Puerto Rico debt to boost their returns.
Since it became junk, many reduced that exposure and the market for the commonwealth's paper has "changed quite a bit," Williams said.
Nuveen Asset Management, which oversees about $100 billion in munis, holds almost no commonwealth debt, while Vanguard Group Inc., which manages $140 billion of munis, cut its stake by about half, to $257 million, according to Bloomberg.
OppenheimerFunds Inc., one of the largest holders of debt from Puerto Rico, declined to comment last week on its own or the market's interest in the upcoming PRIFA deal.
Bonds from Puerto Rico accounted for about $5.6 billion of the $26.2 billion invested across the money manager's 20 municipal funds as of Jan. 1, according to data compiled by research firm Municipal Market Analytics.
The fund family has also outperformed many of its peers since 2010 thanks partly to the attractive yields of its Puerto Rico holdings.
While analysts agree that hedge funds will support the new deals, Nguyen said their attention may be curtailed by the availability of single B-rated corporate bonds with comparable double-digit yields in the oil and energy sectors, for instance.
"Last year there was no other competition, and this year there is a lot of competition," Nguyen said. These alternatives, he said, could distract hedge funds if they decide to avoid "something as politically messy as Puerto Rico" and opt for a sector, like energy, that they know well.
