Puerto Rico’s new liquidity providers
@Morgan_03 HFs are the new liquidity providers and it don’t come cheap
— Guillermo (@groditi) November 12, 2013
There are plenty of stories about how hedge funds are being lured into buy Puerto Rico debt by big dealers. The Wall Street Journal wrote about hedge funds buying distressed debt. Bloomberg reported that Morgan Stanley, Citigroup and Lazard are holding information sessions for hedge funds to learn about Puerto Rico debt. A trader passed me the presentation from the Citi meeting. It was a detailed explanation of the seniority of Puerto Rico debt and the legal covenants and trading history of specific Puerto Rico issuers and authorities. I would guess Morgan Stanley and Lazard did an equally good job on the background for their clients.
Everyone in fixed income markets has been hunting for yield. It’s easy to see how Puerto Rico debt, with its hefty yields, could be attractive to alpha-searching hedge funds. Hedge funds can’t take advantage of the municipal bond tax exemption, so yields for them are not as high as they would be for a risk-loving retail investor. But hedge funds have the advantage of using leverage to buy assets. This leverage usually comes in the form of loans from the hedge funds’ prime broker. Prime brokers are the large dealer banks that provide financing, trading and back-office services to their hedge fund clients. Morgan Stanley is the second-largest prime broker in the U.S. and Citigroup is seventh largest, according to Hedge Fund Alert. These two dealer banks were prime brokers to about 1,800 hedge funds in the first quarter of 2013.
Hedge funds and other buyers that don’t to take advantage of the tax exemption are referred to as crossover buyers. The Federal Reserve does not track the holdings of hedge funds in its “Financial Accounts of the United States” report, (page 98) so we have no official data on how many hedge funds are buying municipal bonds.
There is historical data available from the MSRB and Sifma showing the most actively traded bonds. Puerto Rico captured 14 of the top 50 CUSIPs traded in the third quarter of 2012, and 8 of the top 50 a year later. Average trade size increased year over year from $133,747 in 2012 to $618,614.
In 3Q 2012, there were 26,930 Puerto Rico trades among the 50 most active CUSIPs (suggesting retail activity), versus 8,206 trades in 3Q 2013. Trade size quadrupled year over year to $633,000 (suggesting increased institutional trade activity).
Given the near junk status of Puerto Rico’s bonds, there is a very limited set of institutional buyers whose mandates allow them to buy this debt. Mutual funds, which have been the most active buyers of Puerto Rico debt, have faced massive redemptions and are generally not available to absorb more bonds. Commercial banks and insurance companies would be put off by the low credit quality of Puerto Rico’s BBB-/Baa3-rated general obligations.
Hedge funds could become a good investor pool for Puerto Rico debt, as long as they are aware of how illiquid the space is. The structure of muniland is scattered into 50 sub-markets. Only the general obligations of the larger states are relatively liquid for trading.
Bank regulators recently announced that municipal bonds may not be used by the largest banks (which dominate muniland trading) when they determine their “high quality liquid assets” for capital adequacy purposes. This move may cause big banks to hold fewer municipal bonds as core capital.
The selloff of Puerto Rico debt from mutual funds stretched the municipal market to the breaking point in September. Hedge funds would be welcome providers of liquidity in a weakened market. Puerto Rico’s economic problems persist, but hedge funds may create a floor under the price of Puerto Rico debt and buy the island some time.
This post was updated to include charts from the third quarters of 2012 and 2013. It previously showed the second quarters.