Muni-bond funds return to Puerto Rico

Impending court approval to restructure more than $17 billion of sales-tax-backed debt would be a major step in the U.S. territory's record-setting bankruptcy

Jan 31, 2019 @ 12:49 pm

By Bloomberg News

Traditional bond buyers are going back to Puerto Rico.

After shunning the U.S. territory for much of the past six years, municipal-bond mutual funds are again buying the government's debt as it recovers from the 2017 hurricane and inches closer to winning a potential court approval to restructure more than $17 billion of sales-tax-backed debt, a major step in its record-setting bankruptcy.

Pacific Investment Management Co. held about $506 million of commonwealth securities as of Sept. 30, nearly 10 times the $52 million held the month before Hurricane Maria, according to data compiled by Bloomberg. AllianceBernstein increased its exposure to $347 million, as of Nov. 30, up from $53 million in August 2017. Capital Group and Massachusetts Financial Services Co. increased their exposure by nearly 50%.

(More: OppenheimerFunds stays uniquely committed to Puerto Rico's muni bonds)

The increase comes after the price of Puerto Rico bonds rallied on expectations that a stream of federal disaster aid and private insurance cash will give a jolt to Puerto Rico's economy, which has shrunk in the past decade. Its bankruptcy may also speed up this year if a court signs off on the restructuring plan for its sales-tax bonds that would address about a fourth of the island's $74 billion of debt, freeing Puerto Rico to strike similar deals with other creditors.

"It's a very good likelihood that you'll have good growth in the next four to five years and so you have a lot of money that will be spent on the island — so that's good for the economy and that's good for tax collections," said Guy Davidson, director of municipal investments at AllianceBernstein, who helps oversee $42 billion of state and local debt. He said the firm may boost its Puerto Rico holdings if prices are low enough. "They're starting to strike negotiations and come to settlements so the legal risk seems to be cutting down."

In the years before Puerto Rico's fiscal crisis, municipal mutual funds were big buyers of the government's bonds, which paid relatively high yields and are exempt from local, state and federal taxes. But many mutual funds in 2012 began reducing their exposure as former one-term Governor Luis Fortuno — who creditors viewed as focused on spending cuts — faced a tough re-election.

By 2013, concern of a Puerto Rico default grew and many mutual funds and individual holders sold their commonwealth securities, pushing the value down to distressed levels. Hedge fund swooped in, eager to pick up cheap bonds sold by a U.S. territory that — at that time — didn't have the ability to file for bankruptcy.

The renewed attention from traditional municipal-bond investors is welcome news for those hedge funds, who hold about 30% of Puerto Rico's debt. As the firms exchange the island's existing bonds for new, restructured ones, they may want to sell those securities to traditional investors to reclaim their cash.

(More:Rise of Puerto Rico bonds has investors' minds blown)

Muni buyers showed interest in a restructuring of $4 billion of Government Development Bank debt, under which investors received $2.6 billion of taxable bonds. Once those new securities began trading, some mutual funds purchased them, including Frost Investment Advisors, AllianceBernstein, SEI Investments Co. and Bank of New York Mellon Corp., according to their most recent filings.

AllianceBernstein may double the more than $300 million of Puerto Rico debt it holds if prices fall low enough, Mr. Davidson said. He and other investors anticipate commonwealth debt will cheapen once the island executes more restructurings and hedge funds start selling those new bonds back to traditional municipal-debt buyers.

"We would think Puerto Rico is going to play a big part of most municipal high-yield funds' structure at some point and so we've been buying," Mr. Davidson said. "We put a small amount into those accounts that allow high yield and we could easily double that should the prices fall enough."

There are still risks. The bankruptcy could face delays if U.S. District Court Judge Laura Taylor Swain rejects the sales-tax debt deal, and the island's federal oversight board is seeking to have $6 billion of general-obligation bonds invalidated in court. If the economy fails to grow as expected, bondholders could face a second round of restructuring if Puerto Rico is still unable to pay its debts.

Capital Group is looking to create strong risk adjusted returns for its clients, according to Karl Zeile, fixed income portfolio manager at Capital Group. "While we have increased our positions in select Puerto Rico credits over the past 12 months, overall the region remains a relatively small portion of our municipal portfolios," he said.

Investors say record-low prices on Puerto Rico bonds following Hurricane Maria and progress on the bankruptcy have brought them back. General obligations with an 8% coupon traded as low as an average 21.8 cents on the dollar in December 2017, according to data compiled by Bloomberg. The debt changed hands Wednesday at 46.3 cents.

(More: Hurricanes that ravaged Puerto Rico also wreck its bonds)

But some funds are limiting some of their purchases to insured debt. Massachusetts Financial held $1.17 billion of Puerto Rico securities as of Nov. 30, a 48% increase from before the hurricane. Most of that debt is guaranteed against default, said Geoffrey Schechter, portfolio manager at Massachusetts Financial, which oversees $13 billion of municipal assets.

"If those bonds basically didn't pay anything we felt that the bond insurers could continue to pay claims through maturity," Mr. Schechter said. "And they were being undervalued at times by the marketplace."


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