Puerto Rico bonds crash high-yield municipal debt party

Thu Jul 17, 2014 1:15am EDT
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By Hilary Russ

NEW YORK (Reuters) - It looked like there was no stopping the runaway returns for high-yield U.S. municipal bonds earlier this year. But that has all come to a screeching halt in the past few weeks thanks to a bombshell coming out of the Caribbean.

The island of Puerto Rico shocked investors by passing a law that gives its government-controlled corporations the ability to restructure their debt. Until that point, many investors assumed that the government of the U.S. territory would stand fully behind the bonds, although there was never a promise to do so.

The impact has been dramatic because Puerto Rico’s government and related entities have $73 billion of outstanding debt, nearly $20,000 for every resident of the island, and it has been widely held by U.S. high-yield muni funds. Some of the biggest funds were heavily overweight in Puerto Rican debt and have taken a battering as a result.

The benchmark Barclays High Yield Municipal Bond Index, which had been up more than 9.5 percent for the year as of mid-June - when it looked like it was going to have its best year since record-beating returns in 2009 - is now up only 5.9 percent.

The hit Puerto Rico bonds have taken following the law's passage accounts for a sizeable portion of the drop off in performance. Puerto Rico's weighting in the index has surged to 29.3 percent from less than 5 percent at the start of the year because more of its debt qualified for inclusion after it was slashed to junk by U.S. ratings agencies.

"Puerto Rico had a significant impact on the performance in high yield," said James Colby, chief municipal strategist at Van Eck Global.

Colby and some other investors expect the sector to remain under pressure given they see little chance of a sustained turnaround in Puerto Rican debt anytime soon.

"We’re not looking at the bottom, near term or any time soon," he said.   Continued...

A woman walks at the headquarters of the Government Development Bank of Puerto Rico, which issues municipal bonds which are widely held and popular in the U.S. tax-free bond market, in San Juan May 10, 2012.  REUTERS/Ana Martinez