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New Puerto Rico Priority: Allaying Investor Fears

For Puerto Rico allaying fears of default in the investor community has become almost as important as fixing its finances.

Because of these fears, over the last 15 months and particularly in the last two months market participants have been demanding increasing yields to hold Puerto Rico paper. This is despite the fact that muni analysts have largely applauded the steps taken by new Puerto Rico Gov. Alejandro García Padilla to address its persistent budget deficits and sagging pension system.

While Puerto Rico succeeded in selling $673 million in Puerto Rico Electric Power Authority bonds in early August, it had to pay yields up to 7.12% for its 30 year maturity on bonds rated BBB by Standard & Poor’s, BBB-minus by Fitch Ratings, and Baa3 by Moody’s Investors Service, and has not sold any other bonds this year.

At some point it will need to return to the bond market and at this point investor sentiment may be as big an obstacle as objective credit conditions.

Though Puerto Rico munis have rallied on the secondary market since mid-October, they are still trading far higher than munis with the same ratings.

For example, on Wednesday a customer bought $1.08 million of first subordinated COFINA bonds with a 26 year maturity at 8.33%. These are rated A3 by Moody’s and A-plus by S&P and Fitch. By comparison, Municipal Market Data said the average yield to maturity for an A-rated general obligation bond with a 26 year maturity was 4.71%, 362 basis points less.

On Thursday $500,000 of Puerto Rico Aqueduct and Sewer Authority senior lien bonds with a 25 year maturity sold in an interdealer trade at 8.12%. These are rated Ba1 by Moody’s, BB-plus by S&P and BBB-minus by Fitch Ratings. MMD said across the United States BBB GO bonds with 25 year maturities were averaging 5.25%, 287 basis points less.

On Tuesday a customer sold $100,000 of Puerto Rico GO bonds with a 27-year maturity at 8.53%. All three ratings agencies rate these at BBB-minus or the equivalent. MMD said across the United States BBB rated GOs with 27-year maturities were trading at 5.28%, or 325 basis points less.

Effectively, market participants are operating under the assumption that there is a much higher chance of default than Puerto Rico’s ratings reflect.

In a 2012 report S&P said that over the 10 years from the time munis were rated BBB-minus, 0.92% of them defaulted. Over five years just 0.43% defaulted.

On Monday, Moody’s Analytics released a report indicating that the credit default swap market is treating Puerto Rico munis as if they have a 15.6% chance of defaulting in the next five years. Of all the states and sovereign nations that Moody’s Analytics looks at, CDS investors only see Argentina as more likely to default in the next five years. Moody’s Analytics operates separately from Moody’s Investors Service.

Why have bond investors been more skeptical of Puerto Rico than the ratings agencies?

With poor fiscal results coming in and a promise to reform the island’s pension system unfulfilled, the ratings agencies dropped the commonwealth’s GO rating to BBB-minus in late 2012 and early 2013. However, with a new administration having come in, the agencies chose to give it time to show results, said Janney Capital Markets managing director Alan Schankel.

After 10 years of deficits and deficit financings in Puerto Rico, investors have grown more skeptical, Schankel said.

Municipal Market Advisors managing director Robert Donahue mentioned the role of the press. “Some investors, particularly retail, who may not have fully understood the difficult economic, demographic and financial challenges facing the commonwealth, sold when negative news headlines reached their doorsteps,” he said. “The commonwealth did its best to react to these headlines but many investors reacted abruptly by selling to contain their losses.

“The price deterioration [of Puerto Rico munis] also begat more selling as net asset values declined in certain funds, causing shareholder redemptions,” Donahue continued.

Puerto Rico has also hurt itself through weak disclosure practices, Schankel said. However, the García Padilla administration has taken important steps to improve this, he said.

“In the past, ratings may have had a greater impact on yield levels, however the rating agencies have lost a lot of credibility in recent years,” said Axios Advisors managing partner Triet Nguyen. “Market participants have also realized that ratings only provide a one-time snapshot of the credit and they may become ‘stale’ over time as the underlying credit may change quite rapidly.”

This does not mean that Nguyen thinks the extreme skepticism about Puerto Rico in some quarters is warranted. In a piece titled, “Fear-Mongering in Today’s Municipal Bond Market,” Nguyen wrote, “After more than 30 years as a market practitioner, I’m still constantly surprised by how much bond prices can be significantly affected by what is widely considered as ‘old news.’ Nowhere is the muni market’s inefficiency more evident than in its reaction to the Puerto Rico situation. The island’s precarious fiscal and economic condition has been known and widely debated for years.”

In late August, Barron’s published a cover article titled ‘Puerto Rico in Trouble.’

“The article contained little new credit information, yet it has increased selling pressure on Puerto Rico paper and pushed Puerto Rico spreads wider by another 100 basis points in the span of a few days,” Nguyen wrote in the article that appeared on Muninetguide.com. “We’ve been among the toughest critics of Puerto Rico issuers. However, we’ve also given credit where credit is due. We’ve applauded the García Padilla administration’s efforts to deal with the commonwealth’s revenue collection problem while still worrying about the continuing decline in economic activities.”

Investor appetite for Puerto Rico’s debt was hurt by Detroit’s bankruptcy in July, analysts said.

AllianceBernstein director of municipal credit research Joseph Rosenblum said that holders of Puerto Rico debt have sold for technical as well as credit reasons.

Analysts say another reason for the discrepancy between the bonds’ ratings and where the bonds are trading may be that the ratings agencies are hesitant to lower most of Puerto Rico’s rating below investment grade.

“A downgrade to below-investment grade may become a self-fulfilling prophecy as it may trigger higher collateral requirements for the commonwealth’s swaps,” Nguyen said.

“It’s notable that appropriation debt of Puerto Rico is rated the same as GO, even though for all states, appropriation debt is one or two notches lower than GO,” Schankel said. This is true for S&P. Moody’s, in contrast, has lowered the public finance corporation appropriation bonds, Puerto Rico Aqueduct and Sewer Authority revenue bonds, and the Highway and Transportation Authority subordinate revenue bonds to the speculative Ba1 rating. Fitch does not rate the appropriation debt.

Schankel and Donahue said it was fairly important that Puerto Rico get its bond yields to lower levels. “Because Puerto Rico depends on market access to refinance bridge loans and bond anticipation loans as well as to restructure its debt service in FY2014, it is very important that the commonwealth’s debt yields normalize,” Donahue said.

On Sept. 20 Moody’s issued a report that said that the widening spreads increased Puerto Rico’s refinancing risks.

“The commonwealth’s financial plan for the remainder of the current calendar year includes between $500 million and $1.2 billion of debt issuance, which it plans to execute over the coming months,” a government spokesperson said. “However, the commonwealth has the flexibility to alter such plan and does not need to go to the market in fiscal year 2014 to meet its financing obligations. We have the flexibility necessary to make adjustments, as appropriate, to account for changing market conditions.”

Treasury Secretary Melba Acosta Febo told Reuters recently that Puerto Rico is seeking yields below 7% before it will sell.

In the last several months Puerto Rico has taken steps to better communicate its message to investors. In the summer the Government Development Bank of Puerto Rico replaced public relations firm Joele Frank with two other public relations firms, SKDKnickerbocker and Sard Verbinnen. Bloomberg Businessweek recently called the latter firm, “Wall Street’s go-to crisis PR firm.”

Leaders of the GDB and the Treasury have met with journalists. Puerto Rico is now advertising on The Bond Buyer’s web site.

On Oct. 15 the government hosted a web and phone presentation for investors in which the governor himself participated. The presentation has been widely praised and some have credited it for the subsequent declines in Puerto Rico’s yields in the secondary market.

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My good friend Triet Nguyen's comment about the self-fulfilling prophecy raises a difficult question--to whom does a rating agency have a fiduciary duty? The issuer? The investors? And what happens if there is potential conflict, as may be the case if a downgrade triggers a liquidity lockup? I don't have an answer to this fundamental question and am eager to hear all sides.
Posted by csandmel | Friday, November 01 2013 at 1:51PM ET
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