Puerto Rico Buoys Hedge Funds After Agency Reprieve: Muni Credit

Aug 18, 2014 9:08 am ET

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Aug. 18 (Bloomberg) -- Puerto Rico bonds are set to extend the longest rally since May after the island’s cash-strapped electric agency won a reprieve from restructuring assets. Hedge funds, with a growing stake in the securities, stand to gain.

Puerto Rico obligations have surged about 6 percent in their six-week advance, S&P Dow Jones Indices show. The gain is quadruple that of the broad municipal market, where benchmark 10-year yields fell to the lowest since May 2013.

The rally is a boon for the more than 60 alternative fund managers that Fitch Ratings says hold a combined $16 billion of Puerto Rico debt. Prices may keep rising after the utility, known as Prepa, said Aug. 14 that it delayed bank loan payments until March and agreed to name a chief restructuring officer next month. The deal probably pushes off a restructuring to next year, Moody’s Investors Service said on Aug. 15.

“It’s a longer extension than expected, and it takes the Puerto Rico contagion risk off the table for this year,” said John Miller, co-head of fixed income in Chicago at Nuveen Asset Management, which oversees $92 billion of munis.

Speculator Getaway

The self-governing commonwealth and its agencies, which have operated for years on borrowed money, have $73 billion of bonds. Most of the debt is tax-exempt nationwide. The Caribbean island in the past year has drawn more alternative asset managers and distressed buyers speculating on price swings, rather than typical muni investors seeking tax-free income.

A group led by New York-based Brigade Capital Management, Fir Tree Partners, Monarch Alternative Capital LP and Perry Capital LLC has offered Puerto Rico financing. The coalition said it added eight firms last week, bringing capital among its 27 members to more than $300 billion.

“It’s a sign of the times in terms of scant distressed opportunities out there,” said David Tawil, president of hedge fund Maglan Capital LP in New York. The $75 million hedge fund owns Puerto Rico general obligations, he said.

The group “is a who’s who of the distressed world,” he said. “The fact that they have the wherewithal to carry the commonwealth if they need to is a good thing.”

Yield Appeal

U.S. mutual funds own about half of the island’s bonds, Fitch said. OppenheimerFunds Inc. and Franklin Resources Inc. together hold about $23 billion, or 35 percent.

Distressed buyers, hedge funds and some muni mutual funds have been lured by the yields on the territory’s junk-rated debt. Its $3.5 billion general-obligation deal in March priced to yield 8.73 percent tax-free, or 14.5 percent on a taxable basis for top earners. At that time, 30-year Treasuries yielded 3.7 percent. Hedge funds bought the bulk of the deal.

Puerto Rico bonds are rebounding from a plunge starting in June after Governor Alejandro Garcia Padilla signed legislation that would let certain public corporations restructure debt. Prepa, the island’s main supplier of electricity, was seen by investors as a likely candidate to use the new law.

Uninsured Prepa bonds maturing in July 2040 traded Aug. 15 at 53 cents on the dollar, the highest since June 26 and up from 33.2 cents on July 10, data compiled by Bloomberg show. The higher price equals a 10.6 percent tax-free yield.

Loss Potential

“People looking for yield right now are saying it’s a roll of the dice, but at these kinds of yields and dollar prices, it’s a calculated risk,” said Dan Toboja, senior vice president of muni trading at Ziegler, a Chicago broker-dealer.

Puerto Rico debt may face renewed losses if Prepa announces that it intends to restructure its $8.6 billion of debt, a likely development, Maglan’s Tawil said.

Prepa’s agreement puts off paying $146 million to Citigroup Inc. unit Citibank and $525 million to a syndicate of banks led by Scotiabank de Puerto Rico until March 31. It must appoint a chief restructuring officer by Sept. 8, come up with a five-year business plan by Dec. 15 and deliver a debt restructuring plan by March 2, according to the utility.

“It buys additional time to go ahead and try to get some consensus around what a filing would look like, what a restructuring would look like,” Tawil said.

The investor group’s $4.5 billion of Puerto Rico holdings consist mostly of general obligations, sales-tax debt and securities issued by the Government Development Bank and Public Buildings Authority.

Those bonds stand to benefit should public corporations such as Prepa restructure debt because the move would buffer the commonwealth from its agencies, said Gary Pzegeo, head of fixed income in Boston at Atlantic Trust Group Inc., which oversees about $4 billion of munis.

Relying on hedge funds and other non-traditional muni buyers comes with risk, Toboja said. While those buyers are interested in the commonwealth’s fiscal standing and pledge to provide financing, their views may shift, he said.

“If this stretches out into several years, maybe their priorities change,” Toboja said. “Maybe they put their capital into other areas.”