Analysts are saying that when Puerto Rico next comes to market to sell bonds, it will have to pay a high yield and will only succeed if it shows more progress towards fiscal health.

The current fiscal 2013 budget was designed assuming that Puerto Rico would refinance $775 million in debt, according to investor outreach from the Government Development Bank of Puerto Rico and the Department of Treasury dated March 22. Puerto Rico would be refunding $600 million of general obligation bonds and $175 million of government guaranteed Public Building Authority debt. The new fiscal year begins July 1.

GDB president Javier Ferrer has said the debt will be sold by the end of the fiscal year, though a spokeswoman told The Bond Buyer, "GDB is monitoring market conditions to complete this refunding (bond take-out) and there is no particular timeframe established."

Over the last four months, Standard & Poor's and Fitch Ratings have downgraded Puerto Rico's general obligation bonds to BBB-minus, while Moody's Investors Service has downgraded it to the equivalent Baa3. Yet it is over a longer nine-month period that investors' concerns about Puerto Rico's debt have been growing.

This is evidenced by the trading of its debt at substantially higher yields than its rating generally commands in the market. For example, as of early April, 10-year Puerto Rico GO bonds were trading roughly 160 basis points above Municipal Market Data's BBB GO scale.

On April 4, the Puerto Rico legislature passed a reform of its pension plan that Fitch and S&P hailed as a credit positive.

Despite the reform, the secondary market continues to ask for more yield.

Over the last 12 months, the 10-year Puerto Rico GO has had an average spread of 255 basis points over the AAA scale, according to Daniel Berger, senior municipal strategist with MMD. As of the end of April 3, the day before passage of the reform, the spread was 310 basis points. A week later, the spread had increased to 330 basis points, a 12-month high.

At this point, the spread is only 10 basis points less than its maximum during the 2008-2009 financial crisis, in February 2009, Berger said.

With all this investor concern, how will the market react when Puerto Rico comes to it to sell $775 million? Six of eight analysts contacted for this story said for the bond sale to succeed, Puerto Rico will have to offer a high yield and-or show additional steps towards fiscal health.

"It's difficult to peg," said Joseph Pangallozzi, managing director at BlackRock. "There is a bias toward spread-widening compared to where Puerto Rico is trading today. It depends on the market at the time."

John Mousseau, manager of fixed income at Cumberland Advisors, agreed that it was hard to say how the market would receive the bonds. "There's going to be a lot going on between now and then."

If Puerto Rico sells 30-year bonds, it would probably have to offer yields over 6%, Mousseau said. As of Thursday evening, the 30-year Puerto Rico GO was trading at 5.67%, according to MMD.

Other analysts said for the bond sale to succeed, Puerto Rico would not only have to offer extra yield, but would also need to provide positive fiscal news in the next few months.

The pension reform would help, Janney Capital Markets managing director Alan Schankel said shortly before it passed. The Treasury Department is looking into expanding the product and service base underlying the sales and use tax, which could increase revenue by $550 million. If the administration of Gov. Alejandro García Padilla succeeds in getting it passed into law, the government will proceed with the bond sale, Schankel said, though the interest rate will not be favorable.

Over the next 11 weeks, there may be good or bad news coming out of commonwealth, said MMD's Berger. The audit of the fiscal 2012 data may come out, with either good or bad news. It is even possible that the rating agencies might downgrade the GO debt before the sale, which would lead to a wave of selling, he said.

The general status of the bond market will also be important, Berger said. As for yield, "at some point there is value; I don't know if we've achieved it yet."

Two other analysts also emphasized the importance of the García Padilla administration taking steps towards fiscal balance.

The reception of the bonds will depend on the content of the governor's proposed fiscal 2014 budget, according to Richard Larkin, director of credit analysis at HJ Sims. "The market will first want to see if Gov. Padilla is putting his money where his mouth is. Failing that, a major new issue by Puerto Rico without a firm plan to bring the deficit under control would face fierce headwinds."

"I say there will be more volatility ahead," said Robert Donahue, managing director of Municipal Market Advisors. "The budget problems still loom and will require more Herculean efforts." The upcoming budget will have to make real progress towards balance to calm the bond-buying community, he said.

The budget deficit was $3.3 billion in fiscal 2009, $2.8 billion in fiscal 2010, $1.8 billion in fiscal 2011 and $2 billion in fiscal 2012, according to Janney. The firm estimates the current fiscal year deficit at $1.9 billion. Others have put it at $2.16 billion. The latter would be 22% of the current year's estimated expenses.

Donahue suggested that mutual funds are less likely to be buying Puerto Rico paper in the near future. They have to look at the market valuations of their Puerto Rico holdings and they may show declines in the near term, he said.

Two other analysts were more optimistic about how investors will receive the imminent Puerto Rico bond offering.

Puerto Rico will have no problem selling them, said Troy Willis, senior portfolio manager at Oppenheimer Funds. The sale will have little impact on the market, he said.

In late March, another analyst said that investors would be interested if there was an additional 20 to 30 basis points added to the yields. The 10-year has since added these amounts.

"I think there's going to be a lot of interest, especially if it's cheap enough," the analyst said. At the end of the day investors do not doubt they will be paid, he added.

The Puerto Rico Public Buildings Authority (Autoridad de Edificios Públicos) is rated Baa3 by Moody's and BBB-minus by Fitch and S&P. As guaranteed debt, Moody's and Fitch treat it like the island's GO debt.

The commonwealth's secretary of justice has offered the opinion that as guaranteed debt the commonwealth's strong GO pledge applies to it, according to Fitch. Puerto Rico's GO debt gets first lien on the government's revenues, according to Puerto Rico's constitution.

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