September 27, 2013 / 12:01 PM / 5 years ago

Puerto Rico's fat yields luring hedge funds, distressed buyers

Sept 27 (Reuters) - Puerto Rico’s municipal tax-free bonds yields are luring a new class of buyers: hedge funds and distressed debt investors betting the Caribbean island will keep servicing its massive debt.

Trading volumes in Puerto Rico general obligation bonds, which are rated barely investment grade and may tumble into junk-bond territory, spiked in mid-September. Yields jumped for a few trading days above the magic number of 10 percent and prompted Puerto Rico finance officials to scale back their 2013 schedule of planned muni market sales.

Hedge funds and other crossover investors jumped at the high yields Puerto Rico debt carried, according to Daniel Leon Toboja, senior vice president of fixed income trading at Ziegler Capital Markets.

“I think the 10 percent was almost psychological ...,” Toboja said. “People took a step back and asked, ‘Is this too cheap?’ It looks like they were right. I do believe they got oversold and dumped.”

Even at current market levels well below 10 percent, Puerto Rico’s debt is paying way more than distressed corporate debt.

Many mutual funds and other traditional holders of Puerto Rico’s $70 billion of high-yield, liquid and triple tax-exempt securities were spooked over the summer by climbing interest rates and Detroit’s historic bankruptcy filing.

A source familiar with Puerto Rico finances who declined to be named said that both hedge funds and commercial banks were among the buyers of Puerto Rico debt since mid-September on the secondary market.

The emergence of distressed debt buyers could work in Puerto Rico’s favor if the extra demand drives down yields, allowing the island to sell debt on better terms. The island cut back its planned debt issuance to between $500 million and $1.2 billion before year’s end.

Hedge funds, such as Monarch Alternative Capital, have scooped up more than $600 million of debts of bankrupt Jefferson County, Alabama. Earlier this year, before Detroit filed for bankruptcy court protection from creditors, some of these investors were reported buying Detroit debt.

“Investors in my space are totally focused on Puerto Rico rather than Detroit ,” said a manager of a distressed debt hedge fund. “It has much more debt and therefore a much bigger impact on the muni market.”

The manager, who spoke on a promise of anonymity, said the island’s debt was also attractive to distressed debt investors because it trades relatively frequently. Puerto Rico’s debt amounts to nearly 2 percent of the $3.7 trillion municipal bond market.

“It’s unprecedented - over $70 billion in muni debt held by many muni mutual funds,” the manager said, adding Puerto Rico was very unlikely to seek bankruptcy court protection like Detroit because is not covered by Chapter 9 bankruptcy law.

Yields on Puerto Rico debt have long been the highest among major issuers in America’s $3.7 trillion muni market but have climbed sharply since July. The yield on a 30-year island GO was 5.49 percent on June 30 and 8.06 percent on Thursday from an 8.58 percent close on Sept. 10, according to Municipal Market Data.


“There have been two bases of investors in the market, one in favor of Puerto Rico bonds and the other against it,” said portfolio manager Robert Amodeo at Western Asset in New York. “Now, a third base of investors are interested in Puerto Rico - distressed investors - because of Puerto Rico’s high-yields.”

While high-yield corporate bonds currently pay 470 basis points over Treasuries, Puerto Rico bond yields offer a spread of more than 500 basis points above triple-A municipal bond yields, according to MMD, a unit of Thomson Reuters.

Puerto Rico bonds, which pay more than corporate high yields, “are clearly on the radar screen for corporate high-yield buyers, they are clearly in their wheelhouse in term of the interest rates of the products they are looking for,” said Chris Mier of Loop capital in Chicago.

Tiny, fragmented bond deals, a typical feature of the municipal bond market, often represent a deterrent for distressed investors - but this is not the case for Puerto Rico’s well-traded and oversized debt.

A widened investors base would help Puerto Rico and its bondholders, Mier said. “It is clearly in their interest that their deals are marketed to a broader audience.”.

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