February 5, 2014 / 11:21 PM / 5 years ago

Investors see Puerto Rico downgrade curbing appeal of its bonds

NEW YORK (Reuters) - Puerto Rico will face trouble selling bonds after Standard & Poor’s cut its credit rating to junk status, spelling possible trouble for the cash-strapped U.S. territory as it tries to push ahead with debt deals worth as much as $2 billion, some big institutional investors said on Wednesday.

A woman walks past a closed restaurant in Ponce, on Puerto Rico's southern coast, February 5, 2014. REUTERS/Alvin Baez

Popular because of its triple tax-free status, Puerto Rico’s outstanding debt totals $70 billion, or nearly four times the $18 billion owed by bankrupt Detroit. Some 70 percent of mutual funds dedicated to tax-free bonds own Puerto Rico bonds, according to Morningstar.

But the ratings cut by S&P, which came in the closing minutes of trading on Tuesday, could sap investor interest, despite the high yields offered by Puerto Rican bonds.

“The island will need to borrow relatively soon to meet its obligations, and it may well find it difficult or impossible to access the market for financing,” said Peter Hayes, head of BlackRock’s Municipal Bonds Group.

Puerto Rico officials said after the ratings cut, which opens the government to as much as $940 million in penalties tied to swaps and other securities, that they are studying financing options and instituting cost savings.

In San Juan, Puerto Rican Governor Alejandro García Padilla said on Wednesday he would seek to renegotiate swaps agreements and other loans that will require accelerated payments.

The island last sold bonds in August and has, according to sources, considered a possible $2 billion financing by institutional investors organized by Morgan Stanley, bond deals and loans by banks on the island.

The downgrade “calls into question whether they’ll be able to bring those offerings to the market,” said Dan Heckman, senior fixed income strategist at U.S. Bank Wealth Management. “It just continues to drive their interest expense higher and higher.”

Some of Puerto Rico’s bond yields now top 10 percent in secondary trading.

Puerto Rico is not likely to get much help from Washington; the White House reiterated on Wednesday that it was not considering a bailout for the cash-strapped commonwealth.

Bill Delahunty, director of municipal bond research at Eaton Vance Corp, said there are many questions that still need to be answered before Puerto Rico can come to market. For example, investors will key on the bonds’ interest rates and credit ratings before deciding if they will be buyers.

Likely buyers were high-yield funds with little or no current exposure and hedge funds, Delahunty said. He declined to discuss his firm’s investment strategy, but said that mutual funds and other traditional buyers were unlikely to be able to absorb all of the bonds.

Lyle Fitterer, municipal bond fund manager at Wells Capital Management, said he would be reluctant to participate in a bond sale if and when Puerto Rico comes to market.

“At the general obligation (GO) basis we would not unless there is some sort of specific revenue pledge that would come with the structure or some security package that would go above and beyond the GO pledge and assign some sort of ... tax.”

Even so, he said that investors who were inclined to buy new Puerto Rico debt would be little influenced by S&P’s downgrade.

“Most people consider it to be a non-investment grade credit, and I think at this point, if you’re buying it, you better be putting it in a place that takes non-investment grade risk,” Fitterer said.

A big investor in Puerto Rico that now looks like an unlikely buyer of the commonwealth’s debt would be the Franklin Double-Tax Free Income Fund FPRTX.O, run by Franklin Resources Inc (BEN.N). Last year, the fund’s exposure to Puerto Rico topped 60 percent, according to Lipper Inc data.

Since the end of July 2012, the fund’s net assets have shrunk to $363 million from nearly $900 million. Franklin Resources was not available for comment.

S&P’s rating announcement, which may be followed by similar downgrades by Moody’s Investor Service and Fitch Ratings, had muted and mixed effects on Puerto Rico bond prices Wednesday despite fears of heavy selling on a downgrade.

“Puerto Rico’s bonds have been already trading in distressed territory since August 2013,” Citigroup Markets analysts said in a commentary. “The downgrade seemed to have been largely priced in.”

Additional Reporting By Karen Pierog in Chicago, Tim McLaughlin in Boston, Lisa Lambert in Washington, Hilary Russ and Edward Krudy in New York, and a Reuters correspondent in San Juan; Editing by Leslie Adler

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