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Puerto Rico and Detroit: Investors Tread Fine Line Between Value and Concern

Correction: This article has been updated to reflect Puerto Rico’s pension reforms and measures to strengthen its public corporations.

In a choice between a rock and a hard place, investors favor Puerto Rico over Detroit.

Trading in distressed credits from Puerto Rico remains active and prices are appreciating in the secondary market, even after the commonwealth was forced to cut back its bond program for the rest of the year after yields on its debt soared. At the same time, muni experts said, activity is extremely limited especially on uninsured bonds from Detroit, which faces a long and complicated recovery after filing July 18 for the largest municipal bankruptcy to date.

Puerto Rico offers a more enticing reward for those willing to take a chance, municipal experts said, as Gov. Alejandro Garcia Padilla tries to address inherited fiscal challenges, strengthen the economy and keep the island’s teetering credit at investment grade.

“They are aware of the risks, but many are willing to take it, feeling that they are being compensated at the current levels,” said Peter Hayes, head of the municipal bond group at BlackRock Inc.

Traders reported sporadic trading of small blocks of distressed Detroit paper in the secondary market as the city squares off with its creditors regarding $1.1 billion of general obligation debt. On Monday, a block of Detroit public improvement limited GOs totaling $10,000 with a 5.15% coupon due in 2025 traded at $74.62, or 8.67% yield, according to trade data from the Financial Industry Regulatory Authority. The bonds are rated Ca by Moody’s Investors Service, and C by Standard & Poor’s and Fitch Ratings.

Its junk-bond ratings, coupled with emergency manager Kevyn Orr’s treatment of the city’s unlimited-tax GO bonds as unsecured, have effectively cut the city off from the markets.

Puerto Rico’s’s GO credits, sales tax-backed bonds, and electric revenue debt remain among its most actively-traded debt, Hayes said,

Distressed Puerto Rico bonds have retreated from the highs of 10% yields offered two weeks ago on new issues, which is a move in the right direction for wary investors, analysts and underwriters said. “There has been a snapback of the same bonds to the 8% to 9% range,” Hayes said. On Monday, FINRA reported a block of P.R. public improvement unlimited tax GO bonds totaling $220,000 with a 5.50% coupon due in 2018 at $95.82, or 6.53%  yield. The bond has appreciated since Sept. 17 when it traded at $91.65, or a 7.61% yield.

There continues to be “volatility for people on the outside looking purely at levels and dollar price,” he added.

“I think a lot of the pressure on P.R. paper is that the market is scared of fund disgorgement,” said John Mousseau, vice president and portfolio manager at Cumberland Advisors Inc. in Vineland, N.J. “After what we saw with mutual fund selling in June through August, we can understand that,” especially since Puerto Rico paper makes up 20% to 30% of some fund managers’ portfolios, he said. “They can’t really afford to take the hit,” Mousseau said, noting that even some insured Puerto Rico credits are trading at 6%-plus yields.

A New York underwriter said yields have retreated from the “extraordinarily high levels a few weeks ago,” a reversal that is building a comfort level among investors and offsets the impact of Detroit’s strain on the market -- which could worsen Oct. 1 when the city is expected to miss its first scheduled GO payment since filing for bankruptcy. Before filing, it defaulted in June on some of its debt, including $530 million of unsecured GOs and $39.7 million of pension certificates.

“If there was any concern [Puerto Rico] would implode and be a complete disaster and put a cloud over our market it subsided, and that has allowed the general muni market to improve,” the underwriter said. “That level of uncertainty is gone and there is active trading in PR paper,” he said, noting that he even saw some yields drop to the high 7% range last week.

According to Hayes, bids for Detroit’s debt emerged when the city’s bankruptcy was first announced in July and followed an initial sell-off as investors searched for recovery value. “A lot of trading volume is frenetic in the beginning,” he explained. “Those people that want to sell, sell and get out, and the buyers buy, then volume settles down.”

Sporadic trades on Monday of some Detroit insured senior-lien revenue debt indicated some stability -- and even tightening -- from trades earlier this month, according to FINRA.

Experts said investors continue to be swayed by the chief differences between the two municipalities -- size and security of their debt -- their potential impact on the market going forward, and the solution that ultimately cure their fiscal struggles.

“Since there is a broad range of opinions on the prospects for the credit, there are both sellers and buyers, and liquidity is enhanced” on Puerto Rico paper, said Chris Mier, managing director of analytical services at Loop Capital Markets. “I have not heard of a situation where a Puerto Rico issue failed to get a bid in the secondary.”

Among other recovery efforts, the Garcia Padilla administration pushed through an overhaul of the government Employee Retirement System in April, and strengthened the operations of its public corporations, such as the Puerto Rico Aqueduct and Sewers Authority, the Highway and Transportation Authority, and the Ports Authority. For instance, the administration adjusted the rates of the aqueduct authority, which brought $300 million in new revenues and allows PRASA to operate without a subsidy from the general fund, easing pressure on the commonwealth's budget.

Indeed, the market has taken more comfort in the commonwealth’s attempts to raise revenues and balance its budget through pension reform, than it has in Detroit’s “rush to restructuring and bankruptcy on the part of Detroit’s state-appointed emergency manager,” said Alan Schankel, managing director at Janney Montgomery Scott Inc. “The risk-reward proposition has improved over the past year because of the increases in yields as well as the improved fiscal picture, with recent administration actions,” he said.

“Puerto Rico certainly has the better outlook in our opinion given the fact that their economy has not declined in the same manner as Detroit,” Mousseau said. “The fact is you are seeing positive movement by the governor in P.R., so that is a good sign. Tourism is up, and another good sign.”

Hayes said the market reaction to Detroit and Puerto Rico’s struggles has been normal – even though some of the price swings have been an anomaly. “The direction of trades and the volume is typical in these scenarios, but it is not normal to go from $110 to $60,” he said.

Apart from the trading activity, municipal experts say the market continues to monitor the ongoing headline risk posed by two of the latest troubled municipalities and weigh the impact of the two recovery scenarios on the overall municipal market.

“Although Detroit’s bankruptcy filing has been a cloud over the muni markets, Puerto Rico, with larger debt amounts and a wide array of holders, represents a much larger systemic risk,” Schankel, said. He noted that Detroit’s obligations are divided among secured and unsecured debt -- with the most questionable issues totaling approximately $2 billion -- compared to approximately $50 billion of tax-secured debt, and an additional $15 billion in revenue debt that account for the commonwealth’s distressed paper.

“Puerto Rico’s various bonds, while also having distinct security features, are often considered together in the same risk bucket due to the impact of the economy on the vast majority of bonds – both taxed backed and revenue,” Schankel said.

Experts predict that the two municipalities should arrive at recovery through different means -- Detroit’s through a lengthy legal process and Puerto Rico’s through budget tightening and revenue generation --which will boost market acceptability and capital market access.

“Detroit is a watch-and-wait approach,” Hayes said. “A lot of what takes place is now in the hands of the emergency manager and the courts.” Meanwhile, if a restructuring were to take place in Puerto Rico, the market would be most concerned with recovery value, he noted. “Puerto has a lot more types of issues and the debt is much larger than Detroit’s,” Hayes said.

At the same time, recent progress by Puerto Rico in terms of revenue growth “does not by any means address their bigger problems of over-leveraging, a weaker economy, and pension problems,” Hayes added. “Puerto Rico still faces a big headwind in the near term.”

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