Bloomberg News

Investors Love Puerto Rico While Pension Bomb Ticks: Muni Credit

May 10, 2012

Puerto Rico has been battling budget deficits for 12 years, has a public pension that’s 9 percent funded and a debt load almost as big as its economic output.

That hasn’t dimmed demand for its bonds from municipal mutual funds catering to investors living in Silver Spring, Maryland, and Virginia Beach, instead of San Juan and Vieques.

OppenheimerFunds Inc.’s Maryland, Virginia and North Carolina tax-exempt funds hold more than 30 percent of their assets in debt issued by Puerto Rico and its agencies, data compiled by Bloomberg show. The bet paid off in the last year as investors hungry for yield and an exemption from local, state and federal taxes bid up securities from the island, which has a lower credit rating than any U.S. state.

“It’s not the first thing that most people would expect when they buy a fund with their own state’s name on it,” Eric Jacobson, director of fixed income at research firm Morningstar Inc. in Chicago, said in an interview. “Investors are courting the income that these funds are throwing off. The question is, do they really understand where it’s coming from.”

With local-government yields at the lowest since the 1960s, investors are looking past Puerto Rico’s chronic budget deficits and the threat of a downgrade from Moody’s Investors Service.

Puerto Rico bonds earned 15.6 percent in the past year, beating all U.S. states and territories and the 11.3 percent return for the $3.7 trillion muni market, Barclays data show.

18th-Best

The OppenheimerFunds $151 million Rochester Virginia Municipal Bond Fund (ORVAX:US) has gained 21.3 percent in the past year. Its 7.9 percent year-to-date return is 18th-best of 587 open-end muni mutual funds, data compiled by Bloomberg show. The Maryland fund is 17th best.

Moody’s in August lowered Puerto Rico to Baa1, three levels above speculative grade, and gave it a negative outlook because of its deteriorating pension fund and history of borrowing to bridge budget deficits. Standard & Poor’s rates Puerto Rico BBB, two steps above junk.

Moody’s last month placed Puerto Rico’s $16 billion of sales-tax bonds on review for downgrade as well.

A cut in the commonwealth’s rating could force selling, Boston-based Breckinridge Capital Advisors said in a March commentary.

“Puerto Rico has systemic risk because it’s so widely and ubiquitously held because of the favorable tax treatment,” said Matt Fabian, a managing director at Concord, Massachusetts-based Municipal Market Advisors.

Yield Differential

Ten-year revenue debt from Puerto Rico yields 3.83 percent, about 1.9 percentage points above AAA general-obligation bonds, according to Bloomberg Fair Value indexes. The gap has narrowed from 2.33 percentage points at year-end.

Much of Puerto Rico debt held in the Virginia fund was issued to finance utilities, highways and schools, and backed by dedicated revenue such as sales taxes and tolls.

The fund’s percentage of Puerto Rico holdings ranged from 23 percent to about 40 percent from 2008 to 2011, according to annual fund statements. As of March 29 it was about 35 percent, according to Bloomberg data.

Tanya Valle, a spokeswoman for New York-based OppenheimerFunds, declined to comment.

The holdings can spur volatility. The Virginia fund returned 47.1 percent in 2009 and lost 36.7 percent in 2008.

“Some of the mutual funds are probably over-weighted on territories,” said Matt Dalton, chief executive officer of Belle Haven Investments Inc. in White Plains, New York.

March Sale

OppenheimerFunds’ state-specific funds have no restrictions on the percentage of investment-grade debt issued by Puerto Rico or other U.S. territories. The funds can invest as much as 25 percent of assets in below-investment-grade securities.

In March, Puerto Rico issued $2.3 billion of general- obligation bonds with 20-year debt yielding 5 percent. That’s equal to a 7.7 percent taxable yield for investors in the top bracket. Puerto Rico got $1.3 billion in excess orders for the sale and boosted it by about 50 percent.

Some portfolio managers who favor near-speculative grade munis are avoiding Puerto Rico.

“Our concern specifically is market access,” said Robert DiMella, co-head of MacKay Municipal Managers, in an April 18 interview in New York. “They need to issue more debt.”

DiMella said he doesn’t expect Puerto Rico to default on its general-obligation bonds. His colleague John Loffredo said almost $4 billion of bonds backed by appropriations from the Legislature will have to be restructured.

Debt Load

The island’s debt-to-gross domestic product ratio grew to 90 percent in 2010 from 57 percent 2001 as officials borrowed to close deficits that have persisted for 12 years, according to Breckinridge. Illinois’s ratio of debt to annual output is 4 percent, according to Breckinridge. Illinois’s A2 Moody’s rating, lowest among states, is two steps above Puerto Rico’s.

Assets in its Employees Retirement System were 8.5 percent of projected liabilities at year-end, according to the commonwealth. By comparison, Illinois’s ratio was 45.4 percent as of 2010, the weakest among all states, data compiled by Bloomberg show.

Governor Luis Fortuno, who is up for re-election in November, last year signed into law annual increases to yearly pension payments through 2021.

“We continue to evaluate alternatives to further extend system assets,” Juan Carlos Batlle, president of the Government Development Bank, said in an e-mail.

“The realistic goal is to at least balance outflows and inflows to meet retirement obligations, protecting the solvency of the plans until the system auto-corrects after 2040,” he said.

Payroll Cuts

Fortuno has cut 17 percent of Puerto Rico’s payroll since taking office in 2009. He also implemented a property tax and an excise tax on manufacturers not based in the commonwealth.

Its economy may grow 0.9 percent in the year ending June 30, the first expansion since 2006, according to the Puerto Rico Planning Board.

Limited supply of tax-exempt bonds in some states pushes fund managers toward Puerto Rico debt.

In Wisconsin, only about 10 percent of debt issued annually is exempt from state taxes, said Lyle Fitterer, a managing director at Wells Capital Management. He oversees a tax-free Wisconsin fund (SWFRX:US) that had about 32 percent of its assets in Puerto Rico debt as of Dec. 31.

About 3 percent of its holdings were uninsured Puerto Rico general obligations that mature in the next few years. About 7 percent consist of longer-maturity Puerto Rico securities backed by dedicated revenue such as sales taxes or tolls. The rest of the commonwealth debt is backed by U.S. Treasuries, securities with credit support from banks that can be redeemed weekly or monthly and federal aid.

“You’ve got to look under the hood,” Fitterer said. “Where we do own, it’s down short. It kind of reflects our view on Puerto Rico that we don’t necessarily think that it’s a default situation any time soon, but we’re worried about a potential downgrade and therefore negative price performance.”

Following are pending deals:

METROPOLITAN ATLANTA RAPID TRANSIT AUTHORITY plans to sell about $327 million in refunding bonds as soon as next week, according to the offering document. The bonds will be backed by tax revenue. Moody’s rates the bonds Aa3, fourth-highest. The debt will be priced competitively. (Added May 10)

CALIFORNIA HEALTH FACILITIES FINANCING AUTHORITY plans to issue $415 million of tax-exempt revenue bonds as soon as tomorrow. Proceeds will help renovate Stanford Hospital & Clinics facilities and refinance debt sold in 2003, according to sale documents. Morgan Stanley will lead the marketing. Moody’s rates the bonds Aa3. (Updated May 10)

To contact the reporters on this story: Martin Z. Braun in New York at mbraun6@bloomberg.net; Michelle Kaske in New York at mkaske@bloomberg.net

To contact the editor responsible for this story: Stephen Merelman at smerelman@bloomberg.net


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Companies Mentioned

  • ORVAX
    (Oppenheimer Rochester Virginia Municipal Fund)
    • $8.67 USD
    • 0.00
    • 0.0%
  • SWFRX
    (Wells Fargo Advantage Wisconsin Tax-Free Fund)
    • $10.99 USD
    • 0.00
    • 0.0%
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