Investors flocked to a $3.5 billion Puerto Rico general obligation deal Tuesday as hedge funds and institutional buyers snatched up the high-yield bonds. The deal, which marks the largest sale of junk bonds in municipal market history, gives the U.S. territory a chance to reroute its economy.
More than 270 buyers submitted $16 billion of orders on the deal, the Puerto Rican government said in a press release, inspiring the Commonwealth Tuesday morning to raise the offering by $500 million from an originally planned $3 billion sale.
Yield on the deal, structured as a single term bond with final maturity in 2035, was 8.73%, more than 500 basis points above triple-A benchmark bonds and 95 basis points higher than yields in the secondary market on Puerto Rico GOs maturing in 2035, according to Municipal Market Data.
"We are pleased where the yield came out," David Chafey, chairman of the Government Development Bank of Puerto Rico, said in an interview. "There was tremendous demand."
Puerto Rico's government came under scrutiny last year as economic concerns sent the Commonwealth's debt soaring to 10% yields and higher on some bonds. In February, Moody's Investors Service, Standard & Poor's and Fitch Ratings downgraded Puerto Rico GOs to junk ratings, citing the island's need to access the capital market.
"The success of this issuance is due to the significant steps the Garcia Padilla administration has made to strengthen the commonwealth's credit profile, as well as the governor's commitment to balance the budget in fiscal year 2015," Chafey said.
Puerto Rico will receive about $3.2 billion in net proceeds from Tuesday's offering, with proceeds of the sale going toward refinancing short-term obligations and swap termination payments, and refinancing certain obligations, resulting in a liquidity boost to the GDB of $1.9 billion, the GDB said in an announcement.
The unique structure of a single term bond with an 8% coupon and a sinking fund beginning in 2021 means Puerto Rico will have time to get its economic house in order before making substantial payments on the bonds.
Traders and analysts familiar with the deal said a typical yield curve and serial bond structure would have made pricing challenging. Puerto Rico's GOs currently exhibit an inverted yield curve, meaning shorter maturities would not have been as beneficial to the issuer.
The structure helped gear the sale for institutional buyers, said Anthony Valeri, a strategist at LPL Financial.
"For a deal that was reportedly five times oversubscribed, I would have expected a slightly lower coupon and towards the lower end of the 8.625% to 8.875% initial yield guidance," Valeri said in an interview. "I think the single term structure was to help facilitate a larger, more liquid bond issue, catering the deal to the institutional buyer base."
A term bond means the island can avoid adding significant debt service in the next seven years, according to Alan Schankel, managing director at Janney Capital Market.
"It's a little more kicking the can down the road," Schankel said.
Market participants speculated in February that high yields on the island's bonds would mean a sale dominated by hedge funds, asset managers and other cross-over buyers that typically do not invest in the relatively low-yielding municipal market.
"The types of buyers were what people expected, crossover buyers, asset managers, and a lot that was driven by hedge funds," one trader who worked on the deal said in an interview. "With minimum orders at $100,000 there will be some retail buyers, but not many."
The successful sale, met with heavy demand from investors, indicates many in the market believe the territory will overcome its financial struggles.
"The strong demand as well as the sheer number and diverse cross-section of investors who participated in today's offering are a testament to the progress Puerto Rico has made in addressing its fiscal situation and enhancing credibility with investors," James Henn, managing director in the municipal products division at Barclays Plc, the lead underwriter on the transaction, said in an email.
While hedge funds propelled much of the buying on Tuesday, the unique buyer base on the deal means the bonds could experience a selloff earlier than with traditional muni buyers, according to Triet Nguyen, managing partner at Axios Advisors.
"At these levels they may not stick around very long," Nguyen said in an interview. "Early on, they talked about cashing out at this point, so it will be fascinating to see what happens over the next month or so if there's an absence of positive news."
The 8.73% yield offered on the bonds Tuesday compares with AAA benchmark yields of 3.58% and Puerto Rico GOs currently trading at 7.78%, according to MMD.
"Maybe you'll see some sell-off, which is not at all good for the market," Nguyen said.
The completion of the deal at lower than expected yields follows recent recovery of Puerto Rico bonds in the secondary market, both of which help improve the perception of the commonwealth in the eyes of investors, John Donaldson, director of fixed income at The Haverford Trust Company said.
"I think it lessens fears of contagion, which helps overall psychology," Donaldson said in an interview.
Municipal bond yields have rallied since the beginning of the year, as issuance in January and February slumped to decade lows. The lack of new bonds has enabled issuers to bring bonds at more expensive levels and caused secondary market trading to firm.
"It's a favorable macroeconomic environment right now, but low supply didn't drive the demand for this," the trader said. "The market has been well positioned for it."
The spread of AAA 10-Year bond yields to Treasuries maturing at the same time was the most negative since July 2011 on March 6, data from MMD show.
"Puerto Rico had to maximize this window to the market and it made sense to upsize," LPL Financial's Valeri said. "The greater the proceeds, the more time it provides PR to get their finances in order."
The new deal buys Puerto Rico much-needed time, but the island still faces a very heavy debt burden, Valeri said.
"If economic improvement doesn't materialize over the coming two years, then a default or debt restructuring is back on the table," Valeri said.
Standard & Poor's analyst Dave Hitchcock said the rating agency will be waiting to see what the net proceeds from the sale will be. S&P will reevaluate the commonwealth's liquidity needs and determine if an action on its current CreditWatch status is merited, Hitchcock said.
The deal marks the first step towards a potential turn-around, according to Patrick Early, chief municipal analyst at Wells Fargo Advisors.
"I think just getting the deal done will help stabilize the P.R. market to an extent, as the deal will help with the island's liquidity, which should reduce the perception of near-term risk," Early said in an interview.
While the initial offering was geared toward institutional investors, a minimum purchase denomination of $100,000 means some retailers may have participated in the deal, Axios Advisor's Nguyen said. The bonds were free to trade beginning at 3:45 p.m. Tuesday.
"You're going to still end up with some retail buyers and, not really the odd-lot types, but a fair amount of individual investors that can meet that requirement, and smaller money-managers or RIAs," Nguyen said. "At the end of the day there will be a lot of people in the deal, which will make any potential workout a lot messier."
Many brokers and advisors at the largest wealth management firms have cautioned retail investors away from the bonds. Retail buyers may also be nervous about the term bond structure, Patrick Smith, chief information officer at Granite Springs Asset Management, LLC said.
"The bonds will probably perform pretty well in the secondary market," Smith said. "Most of the orders are not going away orders. It's going to be interesting to see what happens when the bonds are free to trade."
Puerto Rico will not sell any bonds this fiscal year or early next fiscal year, GDB chairman Chafey said.
While prominent bond issuers like Illinois, Texas and New York are scheduled to bring new bonds to market this week, deals done on Tuesday were somewhat overshadowed by the much-awaited $3.5 billion Puerto Rico sale.
"The deals today might be a little bit overshadowed, there's definitely some truth to that," a sales and trading manager in New York said in an interview. "We've had a lot of retail investors ask about Puerto Rico instead of Connecticut or New York's deal this week, even though Puerto Rico is not marketed to them."
Treasury yields were down one basis point each, with the 30-year and 10-year benchmark steady at 3.71% and 2.77%, respectfully. Two-year notes rose were unchanged at 0.38%.
Municipal bond yields measured by Municipal Market Advisors strengthened along the long end of the curve, with yields on bonds maturing from 2034 and out falling as much as one basis point.
