Market Post: Puerto Rico Turmoil May Shake Up Munis

The Puerto Rico sell-off may inject volatility into the market this week, market participants said.

"Market participants should be aware of potential headline-driven broad market volatility from Puerto Rico's challenges in the coming weeks," John Dillon, chief municipal bond strategist and managing director at Morgan Stanley, wrote in a report released on Thursday.

The weekend of June 28, Puerto Rico enacted a law that allows the island's public corporations to restructure debt.

Moody's Investors Service downgraded the commonwealth's outstanding $14.4 billion GO debt to B2 from Ba2 on July 1, because of the new law. Moody's also downgraded a slew of Puerto Rico agencies and public corporations, dropping the commonwealth's Sales-Tax Financing Corp.'s senior and subordinate lien bonds to Ba3 and B1, respectively.

The Puerto Rico Electric Power Authority was downgraded to Caa2 from Ba3, and many other Puerto Rico agencies were also lowered.

Yields on Puerto Rico GOs, COFINA, and PREPA bonds rose after the downgraded, and the yields for bonds from the commonwealth's $3.5 billion March issuance jumped to their highest level ever.

"I would venture to stay an arm's length away from Puerto Rico debt until the issues clear up," a trader in New York said. "We won't know its impact on the market until fund flows come out this week."

Dillon wrote in the report that if there is broader market volatility from Puerto Rico issues, in the absence of rising U.S. Treasury yields, such volatility may be an opportunity for investors to add exposure to non-Puerto Rico municipals.

"However, headline-driven muni risk and UST-driven interest rate risk may facilitate a longer lasting span of price erosion that would need to be monitored for appropriate entry points," he wrote. "Our base case remains one of rising interest rates (eventually). Our target maturity range is 4 to 9 yrs; we prefer above-market coupon securities."

Volume is scheduled to pick up this week, but is still lower than June's levels. Volume is expected total $3.5 billion, compared to $2.8 billion the week before.

"The market is looking for new credits, so new structures will do well," a trader in Chicago said.

The largest deal for this week will be the competitive sale of $300 million of Massachusetts School Building Authority bond anticipation notes.

The other large competitive deals include Wisconsin's $254.8 million GOs and the Florida Department of Transportation's $240 million of revenue bonds.

"It's weird you don't see Florida GOs trade often, but it's a great credit when out there. [It] trades just fine," a second trader in Chicago said. "Florida transportation is a bit higher yielding, it's a good credit, people like it, but has a little more spread to it."

The largest deal in the negotiated market is the Indiana Finance Authority's $250 million of private activity bonds.

Some of the other large negotiated deals for this week include $238 million of Louisiana gasoline and fuel tax revenue refunding bonds and $157.1 million of Massachusetts Port Authority revenue refunding bonds.

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