Even as Puerto Rico's governor struggles to address budgetary shortfalls and avoid decline of its credit quality below investment grade, the commonwealth's triple-B rated debt remains a relatively liquid and actively traded product in the secondary market, according to portfolio managers, analysts, and sales managers.

With the downgrade a week ago of two separate commonwealth-issued credits, the island's declining fiscal health is creating trepidation among retail investors and rating agencies and prompted swift action last week from Gov. Luis Fortuño.

Tuesday Fortuño proposed cutting 30,000 government jobs and temporarily raising business and individual income taxes by 5% in order to help close a $3.4 billion deficit and preserve the triple-B rating on the island's general obligation debt and other credits.

However, as Puerto Rico's debt has shown little widening beyond that of other triple-B credits, it still offers value, according to Ron Fielding, a senior vice president and senior investment strategist at OppenheimerFunds Inc. in Rochester, N.Y.

"I haven't seen any significant deterioration of bond prices compared to other munis and there isn't, at present, any sign of panic or abandonment by investors of Puerto Rico paper," Fielding said.

The fiscal turmoil, however, has not curtailed trading volume in the secondary market.

Ken Meiselman, executive vice president of J.B. Hanauer & Co., said he has observed a substantial amount of bonds out for the bid in recent weeks, though not as many as there were at the end of 2008.

Yields on Puerto Rico debt have risen over the last couple of weeks amid growing fears about the commonwealth's deficit issues, he noted.

"Retail is still buying, but a little more reluctantly because they are more nervous" about the island's fiscal recovery, he said.

The most actively traded Puerto Rico bonds that retail investors are most comfortable with include electric revenue bonds, GOs, and highway bonds, which are trading with yields in the high 6% area on the long end of the market, according to Meiselman.

To take advantage of the current opportunity, Fielding has been adding to his exposure to Puerto Rico bonds over the past six months.

Last Wednesday he cited a block of highway bonds with a 5% coupon due in 2023 trading in the secondary at a 6.45% yield - 251 basis points cheaper than comparable bonds on the generic, triple-A GO scale published by Municipal Market Data at the time of the trade.

Fielding said he owns more than $10 million of the highway bonds - largely in his limited-term New York tax-free fund, with the balance in the AMT-free national tax-free fund. His exposure to Puerto Rico debt averages between 10% and 13% in each of the 15 state-specific and three national tax-exempt mutual funds he manages totaling $30 billion, he said.

The highway bonds are among the cheapest of the Puerto Rico bonds, which have been trading in block sizes ranging from small odd lots to over $1 million.

On Friday morning, for instance, a dealer traded a $10,000 block of insured public improvement GO refunding bonds with a 6% coupon due in 2027 at a 6.35% yield to maturity, according to trade data from the Municipal Securities Rulemaking Board on the Securities Industry and Financial Markets Association's Web site, www.investinginbonds.com. Those bonds were 126 basis points cheaper than the generic, triple-A insured MMD scale at the time of the trade.

Last Wednesday, meanwhile, the site reported a trade of more than $1 million of uninsured public improvement GOs with a 5% coupon due in 2023 to a customer at a 6.47% yield to maturity - which was 250 basis points cheaper than the MMD generic triple-A scale at the time.

By comparison, Fielding noted that the island's triple-B paper was trading within 100 basis points of the MMD scale a year ago.

Like the rest of the market, Puerto Rico bonds have widened noticeably over Treasuries, but Fielding noted that the commonwealth's debt "has not gotten materially cheaper compared to other triple-B paper" over the last 12 months in spite of the island's fiscal stresses.

"Most of the widening is a triple-B issue, not a Puerto Rico issue," he said. "If Puerto Rico cheapened at all, it is no more than 20 basis points" compared to other triple-B bonds.

Generic, triple-B revenue bonds due in 2039 were yielding 229 basis points more than the MMD generic triple-A GO scale, while generic triple-B rated GO bonds due in 2039 were 219 basis points cheaper as of Friday.

Chris Mier, managing director and municipal strategist at Loop Capital Markets in Chicago, said Puerto Rico is among the lower-rated credits that have cheapened overall due to the liquidity, financial, and economic crisis affecting the municipal market, but said some of the widening is specific to investors' concerns of a possible downgrade.

According to research provided by Loop, the widest that Puerto Rico bonds have traded in recent months was on Dec. 23 when a block of at least $1 million of non-callable, uninsured, triple-B-rated Puerto Rico GOs with a 51/2% coupon due in 2018 traded at 392 basis points cheaper than the comparable MMD triple-A GO scale.

That compares to noticeably tight spreads of less than 50 basis points in early 2005, according to Loop data.

Matt Fabian, managing director at Municipal Market Advisors, agreed that spreads on the commonwealth bonds have only widened as part of a "systematic" cheapening in the overall municipal market, but said investors continue to be concerned over the state of Puerto Rico's near-term uncertainty.

"Investors are justifiably concerned that the commonwealth faces a downgrade, will flood the market with cheaply priced deficit bonds, or even need to call on the Treasury for an emergency cash injection," he said.

Fielding said years of overspending has led to the island's third year of economic contraction and paints a "bleak" picture for the possibility of a downgrade compared to a year ago, as well as the potential for significant spread widening under those circumstances.

"It's a very sharp cliff for Puerto Rico from a bond-funding standpoint and its ability to access the credit markets" if the GO debt falls below investment-grade, he added.

Investor fears were heightened two weeks ago when Standard & Poor's dropped the long-term underlying rating of Puerto Rico Highways and Transportation Authority debt to BBB-plus from A-minus, which came on the heels of the agency's downgrade in the same week of $58.5 million of Puerto Rico Port Authority debt issued for the international airport in San Juan to BBB-minus from A-minus.

Meiselman said should the island's credit dip to below investment grade there would be an increase in selling pressure in the secondary market, which would cause yields to return to their late 2008 levels approaching 8%.

But, he said, "if you had Puerto Rico bonds at 8%, I would be surprised if there wasn't demand there." Despite the recent downgrades and fiscal uncertainty, Fielding is optimistic about the commonwealth's recovery.

"There's no question that Puerto Rico is in the most severe crisis of the last 80 years, but the odds that Puerto Rico will be around to pay its bondholders are 50 times greater than they are for large corporations," he said.

He cited the Orange County, Calif., bankruptcy debacle as an example. "Bondholders who held on and didn't panic ultimately recovered all their money over time and that's something that's not going to happen for investors of Circuit City or Sharper Image," he said.

"Even though Puerto Rico is among the most marginal of investment-grade credits, I think in the long-term Puerto Rico is going to be a money-good situation," Fielding concluded.

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