Municipal bond yields were unchanged Monday as trading activity was muted following a downgrade of Puerto Rico bonds on Friday.
The commonwealth's second downgrade to junk left some traders on the sidelines, deterred retail investors, and has contributed an over-arching sense of uncertainty to the municipal market, traders and analysts said.
"Retail is waiting for clarity on a few issues, including Puerto Rico and what's going to happen to funds" if there are additional downgrades of the commonwealth, a trader in Texas said. "The market is bracing for the reaction, it just doesn't know what the reaction will be."
The junk ratings could initiate a selloff or prevent funds from acquiring new Puerto Rico debt, analysts said.
"In a worst case, mutual fund outflows will continue and precipitate additional selling pressure from mainline funds that could push general market levels temporarily lower," Municipal Market Advisors said in a report Monday. "Puerto Rico-driven caution is best recommended at present."
Municipal mutual funds reported $227.3 million of net outflows in the week ended Feb. 6, according to Lipper FMI data. Both Standard & Poor's and Moody's Investors Service cut the Puerto Rico's general obligation bonds to junk that week.
"With only a few trading days since the downgrade, the municipal market has not yet shown what the knock-on effects will be, or who will be affected," MMA said.
Response in the retail investing space was marked by a larger number of bids wanted and selling on Friday, while the institutional market set market-stabilizing bids, MMA said.
"Due to Friday's downgrade, some Puerto Rico debt will be removed from major municipal indices, which increases the possibility of forced selling," Mikhail Foux, an analyst at Citi, said in a report Monday. "Nevertheless, in our view, forced selling, if any, will be only marginal,"
Both Citi and MMA said some mutual funds may be restricted from buying additional Puerto Rico paper due to its below-investment grade rating.
"However, for certain mutual funds," Foux wrote, "the ability to buy PR debt will diminish after the downgrade given restrictions on total high yield allocations."
With new issuance at dismal levels and investors gearing up for a three-day weekend, traders said the spotlight on Puerto Rico is unlikely to fade.
"It's headlines on Puerto Rico again," one trader in Chicago said in an interview. "In a market calendar week that's very thin most of the discussion is about Puerto Rico and some of the ramifications of the downgrades."
Market participants are watching benchmark muni indexes including one by Barclays Plc in which Puerto Rico bonds represent 2.5% of the $1.28 trillion index, the trader said.
"We're going to see what might fall out of the indexes and how that might affect the overall market," the trader said. "There are mutual funds that are going to be forced to sell, depending on what the prospectuses allow. It's hard to quantify what the backstop is."
A two-notch downgrade by Moody's brought Puerto Rico's general obligation rating to speculative-grade Ba2 from Baa3. The service also cut the commonwealth's Sales Tax Financing (COFINA) senior-lien bonds, considered a safer investment, to Baa1 from A2.
The move by Moody's follows a downgrade by Standard & Poor's on Tuesday that knocked the island's GOs one level to BB-plus from BBB-minus.
"There's a very light calendar to start this week with and I think people are going to see what goes on with Puerto Rico," a New York-based trader said. "Things looked kind of unchanged right now."
Potential volume in the coming week is estimated at $2.65 billion, compared with $3.53 billion in sales last week.
Traders on Friday said some retail investors began backing out of Puerto Rico bonds following the downgrade. Many of those traders left at the first signs of trouble last year, the trader said.
"A lot of retail selling came out last year but for anyone that's kind of kept their position since then that downgrade may force some people out," the New York-based trader said. "The quicker that hits mainstream retail the quicker you may see a knee-jerk reaction."
The downgrades are likely to have the most negative impact in the event of a bond sale by the island, traders said. Puerto Rico is expected to bring bonds to market by the end of the month, and some reports have suggested a private placement deal is in the works.
"It's not about the bonds today, the market's priced those," the Chicago-based trader said. "It's going to be about purchasing bonds at new prices and what kind of returns Puerto Rico can give investors."
The municipal market as a whole was slow Monday. Yields were largely unchanged on both MMA and Municipal Market Data scales.
"Overall it's a quiet Monday with munis few and far between," a trader in Chicago said in an interview. "We're not seeing much flow yet."
The week's biggest deal, a Louisiana competitive deal consisting of $347.2 million of tax-exempt general obligation bonds and $149.3 million of taxable, is set to price Tuesday.
"Since it's the biggest deal of the week we'll watch the Louisiana deal to see where it comes in, and what type of structure that comes on," a New York-based trader said. "Could be fairly aggressive given light supply this week but how much just depends on how things go with the calendar."
Market participants will also be watching Janet Yellen's first public appearance as chair of the Federal Reserve. Yellen, formerly the president of the Federal Reserve Bank of San Francisco, is slated to speak Tuesday and Thursday morning.
"Of course we'll be watching Yellen as well," the Chicago-based trader said. "Tuesday and Thursday that will be the market focus. As we're tapering the purchasing now down to $20 billion, I think the way she approaches the Q&A session will be followed fairly closely by the market."
Treasuries were mixed Monday, with the 30-year slipping two basis points to 3.66% and the 10-year falling by one basis point to 2.68%. The two-year yield gained one basis point to 0.32%.
