Puerto Rico’s borrowing goes private

By Cate Long
September 5, 2013

Barron’s ran a cover story last week and more articles followed in the financial press about the economic disabilities of Puerto Rico. These disabilities have been fueling a sell-off of the commonwealth’s public debt. Here is a chart showing the spread (or extra yield) that Puerto Rico bonds have had over the last three months:

You can see that the 20 and 30-year bond spreads have been rising since early June in a consistent pattern. This may be related to mutual funds selling their long Puerto Rico bonds. Thomson Reuters Municipal Market Data senior analyst Daniel Berger describes the situation:

Because Puerto Rico bonds are triple tax they are widely held by some well-known mutual funds. The wider spreads in these names have lowered prices of these muni mutual funds that rely on Puerto Rico bonds for higher income (very important in a low interest rate environment.)

Retail investors have become increasingly skittish about owning some of these funds because they do not know the underlying securities. A lack of transparency and higher interest rates have fueled the 14 consecutive weeks of muni mutual fund outflows. We think that retail investors may be moving more into separately managed accounts where they know what bonds they own.

Berger describes some important macro conditions that affect muniland, like higher interest rates, which always drive bond mutual funds to sell. This is probably more important than retail’s attention to the credit quality of Puerto Rico. Many mutual funds, especially single-state mutual funds, hold a lot of Puerto Rico debt. It’s likely those managers have been selling long Puerto Rico bonds, which have headline and quality risk, to meet redemptions.

But what about the 5 and 10-year spreads of Puerto Rico bonds? Oddly, in the period from June 28 through August 23, spreads were flat. Part of the yield curve was not seeing excessive selling. There were buyers to meet the selling. During the week of August 23rd, spreads broke out of a multi-week stupor. What happened?

One unreported event is that Puerto Rico did a private placement last week of $400 million of Highway and Transportation Authority short term debt. The interest rate on this privately-placed debt begins at 2.56 percent, based on one-month Libor plus 240 basis points (page 4), and it resets weekly. This rate escalates rapidly if Puerto Rico doesn’t redeem the bonds quickly. If Puerto Rico has trouble refinancing the bonds it could end up paying almost 12 percent interest in the 18th month.

Deals like this are a way to force an issuer to refinance the debt as soon as possible. They protect the lender from lending to a weak issuer. Does this selling of short-term Puerto Rico debt partially explain the yield move in the 5-year part of Puerto Rico’s yield curve? If buyers wanted to shorten their exposure to Puerto Rico debt, they could sell 5-year bonds and buy this variable rate paper. Or it could have been new buyers.

The Bond Buyer is reporting that Puerto Rico recently placed $1.4 billion in bonds:

Recently the [Government Development Bank] and the Puerto Rico Treasury Department also privately placed $400 million of bond anticipation notes with Barclays Capital.

Finally, the GDB has already closed $900 million in tax and revenue anticipation notes for the Puerto Rico treasury. Banks in the continental United States and in Puerto Rico bought two thirds of the notes. The GDB bought $300 million.

These two deals are in addition to the August 29 sale of $400 million of Highway debt. But oddly, the Bond Buyer’s numbers add up to $1.7 billion, even though the headline says $1.4 billion. I don’t see any recent filing in EMMA for $400 million and $900 million deals. Is that really what Puerto Rico borrowed?

Widening spreads suggest that trust in the financial condition of Puerto Rico has been weakening. It is critical that there be more disclosure and that the already delayed 2012 Comprehensive Annual Financial Statement be filed this month, as promised. Retail investors already have a fear of Detroit-like municipalities, but at least Detroit filed its financial reports on time. Puerto Rico borrows and yields go up, but muniland knows very little.

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Because dissenting comments never show up here, I predict Ms. Long’s career a pension journalist will be short.

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