Puerto Rico after financing
Puerto Rico brought its long awaited bond offering to market last Tuesday for $3.5 billion, the full amount that was authorized by the Legislative Assembly. Underwriters had talked about the deal as $3 billion, but it seemed obvious given the liquidity needs of the Government Development Bank that it would be upsized it to the full legislatively authorized limit. The bond was structured to mature in 2035 with a 2020 par call.
The deal was priced with an original issue discount of $93 and an initial offering yield of 8.727 percent. This yield was approximately 95 basis points more than secondary market trading for Puerto Rico 2035 general obligation maturity, but in line with with secondary market yield for the bond’s single call par maturity of 2020, according to Thomson Reuters Municipal Market Data.
Puerto Rico’s yield curve has been inverted for several months and the deal seems to have been priced to its par call in 2020, which was trading with a higher yield than 2035 maturities. Reuters reports:
Bigger than an initially planned $3 billion, the sale was oversubscribed, attracting orders worth more than $16 billion from 270 different accounts, according to the island’s Treasury. It drew scores of hedge funds and other non-traditional buyers eyeing fat yields and possible trading gains.
The new bonds were freed to trade late on Tuesday, and they immediately began to rise in price. Yields hovered around 8.4 percent and 8.5 percent, with the lowest reaching 8.352 percent, according to Municipal Securities Rulemaking Board data.
The price Puerto Rico paid to borrow was well below the expectations of 10 percent or higher that prevailed in the market just a few weeks ago.
The bonds appear to have weakened after the market’s initial buying spasm passed. Two $2 million blocks bought late Thursday yielded 8.537 percent, according to Municipal Securities Rulemaking Board. Retail-size lots (less than $100,000) were trading at levels of 8.249 to 8.516 percent.
In the first three days of trading, Puerto Rico’s new bond (Cusip 74514LE86) traded 1,676 times for $2.97 billion of par. On average, according to MSRB’s 2013 Fact Book, new bond issues trade $450 million of par in the first month after issuance.
Of course the size of the Puerto Rico deal means that it would trade in much larger par total and total trades (hopefully an academic can help us out with some historical analysis here). Bloomberg’s Joe Mysak said that the SEC or MSRB should study the trading. This would give a good view of dealer, interdealer and retail order flows and spreads.
Numerous market commentators have suggested that the deal’s initial pricing of 93 was designed to generate massive demand and allow hedge funds and others to flip the bonds for a quick profit. Hedge funds, however, have not generally been active in muniland because most investment-grade deals have such massive demand that underwriters tend to allocate them to their steadiest and strongest customers. In many ways, the Puerto Rico deal may have broken the mold. But will the hedge funds hang around to earn their massive 8.727 percent coupon?
High yield municipal bond expert Triet Nguyen, managing partner of Axios Advisors, wrote in a note about the sale:
Note that we keep emphasizing the ‘short-term’ effect. The hedge funds that did provide support for this record high yield issue are certainly not in for the long haul, driven as they usually are by quarter-by-quarter performance. The pressure remains on the Commonwealth’s leadership to turn the PR economy around over the next 18 months. Unless economic indicators start to stabilize soon, the crossover investors’ patience could wear thin very quickly.
Puerto Rico’s economic indicators are dismal. The Puerto Rico government disclaimed the timelessness of its economic reporting in its bond documents (Preliminary Official Statement page 19) and the accuracy (POS page 13):
The Commonwealth’s macroeconomic data may not accurately reflect the performance of the economy of Puerto Rico.
But we do have historical data from the island’s public electricity utility which shows a 1.6 percent decline in the year over year generation of electricity for January 2014 and an eight percent decline for the last 10 years (the government switched from reporting actual electricity consumption to generation as an economic indicator):
Fox News reported that thirty-five percent of the population in Puerto Rico receives food stamps, a large proportion due in part to a 31 percent increase in the number of Puerto Ricans over 60 who have qualified for benefits. This compares to about 16 percent of Americans receiving food stamps.
American investor John Paulson says that Puerto Rico is “on the cusp of recovery,” but housing sales fell 17 percent in January and deposits in Puerto Rico’s commercial banks fell 3 percent in the fourth quarter of 2013, the third consecutive decline.
Paulson, by the way, just closed on the purchase of several luxury hotels from Puerto Rico’s government. It appears that the government will take a substantial loss on the sale to Paulson (possibly up to 40 percent). As the government makes asset sales, it is important to see if the GDB was carrying the asset at full value and takes a writedown.
The task of Puerto Rico’s political leaders is to reduce the government budget. Puerto Rico Governor Alejandro García Padilla has promised investors that there will be no deficit for the upcoming fiscal year, which begins July 1, 2014. He must do this while simultaneously attempting to jump-start the economy.
Several Puerto Rico legislators are drafting legislation to allow for the restructuring of the Commonwealth’s public corporations. (Spanish version, English translation via Google Translate). Watch this space.
I would encourage all academic economists to closely observe what happens for the next 18 to 36 months to a struggling economy when deficit financing is withdrawn.