Block To Pension Reform Causes PR Yield Hike, Investors Say

Investors say Puerto Rico general obligation bonds' yield spike on Monday was caused by the Puerto Rico Supreme Court's declaration that certain parts of the commonwealth's teachers' pension reform plan were unconstitutional.

Yields on the GO 8s of 2035 jumped up to 9.35%, according to data provided by Bloomberg. That's the highest level yields have reached since the bonds were issued on March 11.

"The court ruling is a real body-blow to Puerto Rico," a muni strategist in Missouri said.

On Friday the high court ruled in a five-to-four decision that several provisions of Law 160 teachers' pension reform were unconstitutional. The commonwealth's government had originally passed the reform in December as part of Gov. Alejandro Garcia-Padilla's efforts to repair the island's collapsing economy.

"The pension reforms are the type of steps that are critically needed in Puerto Rico," the Missouri strategist said. "They have a severe level of underfunding in their pension plan."

Municipal Market Advisors said in a report released on Monday that the Puerto Rico-based Government Affairs law firm Politank believed the justices factored into their ruling the chance that upholding Law 160 could trigger a massive retirement of teachers to avoid the law's cuts.

"Such premature retirements would potentially consume all retirement system assets in short order," MMA said in the report.

Secondary prices on the Puerto Rico GOs began falling on Friday, with trades posting as low as 86 cents on the dollar, compared with 96.6 cents the day the bonds became free to trade.

"There were two million bonds on Friday that traded at 88, and I heard there was an 86 post," a trader in New York said. "Apparently there was a trade that went off at 86, 86.5."

A strategist in New York said he assumed that the court's decision caused the yield hike because investors likely started selling-off the bonds in anticipation of the ruling. The sell-off is a blow to traders that were holding the commonwealth's GO bonds.

"The falling prices are pretty devastating for any of those guys that bought it at 93," the trader in New York said.

The trader said prices will continue to fall because people who are seeing the prices go down are going to cut their losses. "I think it's the worst possible position to be in, to sell a high-yield muni in a time that's not your choosing," a second trader in New York said.

Investors said that the Puerto Rico GO sell-off will have a limited effect on the overall municipal market because the bonds were mainly subscribed to non-traditional buyers, such as hedge funds, when it was first issued. A trader familiar with the buyers list said that of the 265 buyers on the initial sale, 75% were non-traditional muni buyers.

"I think the general muni market, the investment grade muni market, understands the Puerto Rico issue is separate from them," the strategist in Missouri said.

The strategist in New York said that the Puerto Rico GOs are not a traditional muni instrument anymore. "That's the tricky part about this security," the strategist in New York said. "It's owned by non-municipal participants."

The second trader in New York did note that the GO sell-off could have an effect on legacy positions in Puerto Rico names.

"If it has an effect on other credit in the name that funds hold then it absolutely could put some pressure, some downward pressure, on prices," the second trader said.

Investors do not see the GO prices stabilizing in the near future.

"The reality with many of Puerto Rico bond issues right now is that they are in the hand of traders, not investors," the strategist in Missouri said. "So we will see greater volatility in prices because of that very reason."

The first New York trader pointed to the territory's poor economic data as a reason the bonds will not stabilize.

"Puerto Rico's economic recovery statistics remain inconclusive and conflicting," MMA said in the report.

Issuance is scheduled to be $2.6 billion this week, down from $4.39 billion last week, according to data provided by Ipreo and The Bond Buyer. There are no deals over $100 million in both the negotiated and competitive market Monday.

Barclay's Capital Markets will bring $200 million of sales tax bonds for the Massachusetts Bay Transportation Authority to market Tuesday, the largest deal of the week. The bonds are rated Aa2 by Moody's Investor Services and AAA by Standard & Poor's.

The largest deal of the week in the competitive market will be issued by North Carolina for $321.1 million of general obligation bonds. The deal is rated triple-A by all three major rating agencies.

Both MMD and MMA reported that yields for two and 10-year maturities held steady on Monday. MMA data showed the two-year stayed at 0.4% and the 10-year at 2.36%. MMD and MMA data was mixed for long-term yields.

MMD reported that yields for bonds maturing in 14- to 30-years rose one basis point. MMA said yields fell one basis point for the 30-year to 3.73%

Treasuries held steady Monday, as the 30-year yields and the 10-year benchmark were unchanged at 3.49% and 2.64%, respectively. The two-year notes fell one basis point to 0.38%.

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