Puerto Rico failed to make a payment on $58 million of its appropriation-backed debt in August. The island commonwealth’s financial stresses have been evident for some time and its governor warned in July that it would not be able to make payments on $72 billion of outstanding debt.
| The couple more bp for taking on moral obligation debt could now turn into a difference of as much as hundreds of bp|
The August default may not have spread chaos in the US muni market, but it has triggered concerns about the asset class – in particular over what the growth in hedge fund involvement means and whether appropriation-backed debt is riskier than previously thought.
“The highly sensitive money started getting out in 2013 when Puerto Rico’s financing problems started to hit the headlines,” says Thomas Doe, president at Municipal Market Analytics.
Roughly $20 billion remains with domestic funds, a further $20 billion lies with hedge funds, and the remaining $30 billion of outstanding debt is with US mutual funds or individual investors who have accepted their losses.
“The largest money managers such as BlackRock and Vanguard have very little exposure to Puerto Rico – they got out a while back – so if Puerto Rico continues along the current path we won’t see a huge, broad-based market impact,” says the head of a municipal securities division.
Oppenheimer Funds has the largest exposure as a percentage of its muni funds, according to Morningstar.
The knock-on effect on other municipal credits has also been limited. Indeed, Doe says that other lower-grade credits have even been beneficiaries. “In money management it is an AUM game – so you have to invest money somewhere rather than hand it back,” he says. “Puerto Rico’s debt therefore has been replaced [in portfolios] by other muni debt that would not have been bought.”
Certainly other triple-tax exempt issuers like Guam and the Virgin Islands have seen their spreads tighten, but Doe reckons that even risky credits like Illinois and Chicago are seeing a stronger bid than would be expected. “Riskier sector credits are gaining access to capital they have not witnessed since 2006/07,” he says.
Chris Foster, managing director at financial advisory firm NewOak Capital, says: “We’re still in a yield hungry market so when spreads widen and there is nothing else to invest in, then buyers step in. There is a push/pull right now, due to scarcity of supply that is supporting the market.”
The involvement of distressed hedge funds in Puerto Rico’s debt is seen as a double-edged sword. BlueMountain Capital Management holds $400 million in Puerto Rico Electric Power Authority (PREPA) bonds. A further $3 billion PREPA bonds are reportedly held by a group of investors that includes Knighthead Capital Management, DE Shaw and Goldman Sachs Asset Management. Another group of hedge funds and investors calling themselves the Ad Hoc Group holds about $4.5 billion in Puerto Rican debt.
“You’ve got the large distressed hedge fund players involved in Puerto Rico who were in Argentina – you didn’t see them in Detroit and the reason for that is the capital structure of Puerto Rico is so large and diverse,” says Foster. “Some Puerto Rico bonds are trading in the 70s and some are in the 30s, so the hedge funds are going through the bonds in great detail. That is not what high yield muni funds do, nor do they swoop in in distressed markets. They prefer single-A and triple-B bonds trading at 150bp over Treasuries. There is a bifurcation of investors.”
Foster says that can lead to longer and more complex negotiations, which don’t align with what traditional investors want.
“Hedge funds will have no problem cutting education and taking military ships for payment as they are negotiators and have expertise in making money from these situations,” he says. “That can be a drawn-out process.”
Does Puerto Rico offer an insight into how Illinois, and Chicago – which was downgraded to junk status in May due to pensions obligations – will fare?
“Puerto Rico had a deficit and the market financed the deficit for a long time,” says Doe. “At some point Puerto Rico began to lose access to those investors and had to move to alternative buyers with higher rates which closed out their access to financing entirely.
"Are the Chicago credits starting down that path? The market has funded the Chicago Board of Education and the City of Chicago knowing that there are significant pensions issues and a political fight happening in Illinois. There are similarities emerging that everyone is keeping an eye on.”
The biggest difference however is that Puerto Rico, as a territory, is not allowed to file for Chapter 9 like Detroit.
Triet Nguyen, also managing director at NewOak, says Puerto Rico’s treatment of its appropriation-backed obligation (ABO) bonds may offer some insight into how the muni market will evolve. If an issuer defaults on ABO bonds, an appropriation of funds from the state’s pledged general tax revenue is supposed to be made. That pledge, however, is not legally binding on the state.
“It started with Detroit,” says Nguyen. “In the past, appropriation bonds, which belong to the larger category of so-called moral obligation bonds, were more of a gentleman’s market. There was an understanding that issuers could issue bonds without voter approval and pay a little more to the investor but they would get their money back. Investors in turn regarded appropriation debt as pseudo-general obligation debt.
"By putting the pure GO pledge at the bottom of an issuer’s capital structure, the Detroit bankruptcy showed that a muni investor can only count on revenues that have been properly secured, not on a broad full faith and credit pledge. The couple more basis points for taking on moral obligation debt could now turn into a difference of as much as hundreds of basis points.”