To exit Puerto Rico or not to exit Puerto Rico, that is the question.

The commonwealth's worsening fiscal crisis — underscored by a $2.5 billion fiscal year 2013 deficit — has made the decision to curtail ownership an easy one for some mutual fund managers who own troubled credits from the island, municipal experts said.

"We think a lot of funds have been exiting P.R. debt because spreads widened dramatically," said Dan Heckman, senior fixed-income strategist at U.S. Bank Wealth Management.

Between December and March, the commonwealth suffered downgrades of its general obligation debt from all three major rating agencies between, and is currently rated at the triple-B-minus level — just above speculative grade — with negative outlooks.

Debt from the island comprises the largest market among U.S. territories within the $3.7 trillion municipal bond market, making it the most popular and widely-held among funds, according to Morningstar Inc.

Overall, 454 of the 574 open-ended municipal bond funds have exposure to Puerto Rico as of April 10, according to Morningstar. Of the 117 state-oriented municipal closed-end funds, 107 had at least a small allocation to Puerto Rico — four with double-digit allocations — according to 2012 year-end data from the fund tracker. Meanwhile, 320 of the 384 open-end state municipal funds also had some Puerto Rico exposure — about 60 of which were double-digit allocations.

Municipal mutual bond and exchange-traded fund managers are closely monitoring the headlines to gauge whether they should move out of the widely-held, yet nearly-junk paper soon, or stand pat pending proposed fixes by Gov. Alejandro Garcia Padilla and the Government Development Bank, the commonwealth's fiscal arm, municipal experts said.

James Colby, senior municipal strategist and portfolio manager at Van Eck Global, agreed that future credit pressure could create a thinner market for the debt, but said he is among those currently maintaining exposure in the five national, municipal ETFs he manages under the Market Vectors brand totaling $2.2 billion.

"We are not making credit calls to increase exposure or decrease our exposure," he said. "Whether or not we feel that these credits are at risk for further downgrades, we would only consider an outright sale or removal if we felt a monetary default might occur, putting shareholders' interest at risk," he added.

Overall, the firm maintains a 4.9% average exposure to P.R. credits — both investment-grade and below investment-grade — versus the 4.2% overall average exposure maintained by the indexes the firms strives to replicate.

"I would think the risk right now is less weighty on the side of default, but more on the side of price decline. And whether or not the bid side on some of these issues declines a little further, you run the risk of underperforming and seeing valuations decline if you don't sell," he explained.

On Tuesday, a $370 million block of Puerto Rico public improvement revenue refunding bonds traded eight times — three of which were purchases from a customer — at a 330 basis point spread to the triple-A MMD scale, according to Thomson Reuters.

The 5.50% coupon bonds due 2021 traded at an average yield of 4.66%, and are backed by MBIA in the secondary market. The bonds traded on Tuesday as high as 107.2, or a 4.45% yield, and as low as 103, or a 5.04% yield. That was more than 30 basis points higher in yield compared to March 27 when a $50 million block of the bonds traded from a customer at a 4.70% yield, and a 314 basis point spread to the MMD scale.

Heckman said concerns over P.R.'s fundamentals, as well as a dramatic increase in 10-year commonwealth paper — and a 25 basis points spread-widening from where they were the week before the March 20 downgrade — have prevented him from owning any P.R. bonds in the individual portfolios it manages for high net-worth retail investors across the country.

Heckman said the debt does not meet the firm's mandate for high-quality, investment-grade securities. "We saw a crisis brewing that could come as early as next year," he explained. "P.R. debt yields are as high as 4.12%, and to us, that was a very big warning sign," he said last week.

He noted that spreads on certain recent trades in the secondary compared to the triple-A scale are inching closer to the 340 basis-point high seen during the 2009 fiscal crisis.

Puerto Rico is "very dependent" on the municipal bond market and a further downgrade would potentially hurt liquidity, according to Heckman. "It would be very difficult for those with exposure to get strong bids on any bonds" in the event the credit falls below investment grade, he explained. "You will have tremendous selling pressure with yields going up."

So far, however, Colby said he has not witnessed any widespread selling of P.R. debt in the secondary market.

"A little selling has occurred, but not nearly to the extent I thought given all the negative press," he explained. "State-specific funds hold an inordinate amount of P.R. bonds, and you might wonder if you will see selling from those spots, but I haven't seen anything that you consider significant."

Those investors that are maintaining their positions — despite the weakening credit — and are being somewhat bolstered by the passage of pension reform that came late last Thursday, sources said.

In a weekly market update, Matt Fabian, managing director at Municipal Market Advisors, called the development "favorable" for the market and said many participants will use the proposal to "lend credibility to their buying decisions."

"Puerto Rico's new pension reform program, although still of questionable long-term value to the credit, will help some buyers legitimize purchases they'd otherwise like to make to capture badly-needed income," Fabian wrote.

Franklin Templeton Investments, which owns Puerto Rico debt in its national open-ended municipal fund, and Neuberger Berman, which holds Puerto Rico paper in a closed-end national fund, declined to comment for this story. According to Morningstar, other large holders of Puerto Rico debt include open-ended state-specific and national funds at OppenheimerFunds, state-specific closed-end funds managed by Nuveen Investments — which did not respond to queries — national closed-end funds managed by Delaware Investments, and BlackRock Inc. state-specific closed-end funds.

Heckman said the $37 billion of unfunded pension liabilities is just the tip of the iceberg among his growing concerns. Spreads are wider to the triple-A scale and the bonds have performed poorly in recent months given the budget deficit and 14.6% unemployment rate — despite some economic improvements in other areas.

Colby, meanwhile, said he is currently maintaining his holdings and can utilize a process called rebalancing, which provides an advantage over some traditional mutual funds in terms of having an option other than turning to the bid-wanted market to unwind bonds. If, due to a downgrade, bonds are no longer eligible for the index or the firm's three investment-grade ETFs, they can be transferred to Van Eck's $1.1 billion high-yield ETF.

For instance, the firm is currently using rebalancing to move its Puerto Rico Aqueduct & Sewer Authority positions from its investment-grade funds. "We do own PRASA and will seek to move away from that credit as suitable replacements become available," Colby said. PRASA's senior-lien debt was lowered to BB-plus from BBB-minus by Standard & Poor's on March 26 in the aftermath of the GO downgrades.

Overall, the high-yield fund has a 6.7% exposure to P.R. credits — both investment-grade and below investment-grade — while the BarCap Municipal Custom HY Composite Index it tracks maintains a 12.97% exposure.

Meanwhile, he expects there to be potential liquidity in the broader cash market in the event the GO or other credits fall to speculative grade.

"Generally, there is a floor bid that develops from non-traditional players looking to seize an opportunity to restructure failing credits," he explained. "There is the ability of holders to monetize their positions."

Other municipal ETFs with exposure to P.R. debt include iShares S&P National AMT-Free Municipal Bond Fund, and iShares 2017 S&P AMT-Free Municipal Fund, as well as the SPDR Nuveen S&P High-Yield Municipal Bond Fund, and Power Shares insured New York, California, and national funds, according to Morningstar.

Overall, experts said pension reform is a positive for the commonwealth, but more fiscal prudence is needed to avoid further financial and credit deterioration that could damage its liquidity and marketability.

The willingness of the commonwealth to enforce existing measures, such as sales tax collections, is a good start, Colby noted.

"They collect 50% of the sales taxes that are levied, but if they could collect 70% or 75% that would go a long way to reducing — if not balancing — the budget deficit," he explained. "Put that together with pension reform and it creates a very good foundation for structurally improving the fiscal picture for the commonwealth."

Heckman agreed that the commonwealth's efforts toward valuating further tax increases and annual revenues helps the situation, but his firm is still keeping P.R. credits at arm's length.

While he doesn't believe a default is likely, he said the risk for such an event in a few years could be heightened if recovery efforts by the governor and the GDB are unsuccessful.

"All these steps are important but there is still a long ways to go," he said. "We believe you should not only be cautious on the commonwealth, but regular, frequent issuers out of Puerto Rico," Heckman explained. He said PRASA, for instance, is among those "catching a cold from the commonwealth level" and he is wary of that trend becoming contagious.

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