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Bates Research  |  09-19-14

Puerto Rico Approaches New Debt Issue

Puerto Rico will be returning to capital markets within the next month to raise $900 million in needed funds. The issue will be sold as Tax and Revenue Anticipation Notes (TRANs) and, in order to assuage investor concern over possible future bankruptcy, the bonds will once again be governed by New York state law. The last time Puerto Rico tapped capital markets, immediately after its downgrade, it included a similar provision on that $3.5 billion issuance.

Puerto Rico is hoping that the choice of law provisions will help alleviate some investor doubts, but for the most part, they are counting on rising markets to help them place this issuance at reasonable yields. As of September 15, Puerto Rico debt was the best performer in municipal markets for 2014, posting a total return of 12.1% compared to the broader market gain of 7.4%.

The distressed prices that Puerto Rico bonds traded at earlier this year attracted a number of hedge funds who are now acting as white knights in helping the island stabilize its finances, and offering advice on how the government should proceed. According to data provided by Fitch, some 60 hedge funds now control 22% of the island's public debt.

While the rally in prices has brought hedge funds to roost in Puerto Rico, major institutions like AllianceBernstein ($30 billion in municipal funds) are reluctant to invest there. Vanguard, with $140 billion in muni debt funds, is also steering funds away from the island. U.S. mutual funds have been selling out of Puerto Rico holdings as well, according to data from Morningstar, in roughly the past year the number of funds holding Puerto Rico debt has fallen by 20%, from about 77% to 57%. Puerto Rico's below investment grade status has changed the profile of the investor it appeals to; from staid bond funds to alternative investors.

Currently, ten-year Puerto Rico debt is yielding about 8.6%, equivalent to a taxable yield of 14.3%, more than enough to attract alternative investors (who bought most of the last issuance), who will most likely purchase large amounts of this issuance as well. This is probably best for Puerto Rico, since it is unclear where demand would come from otherwise. While the situation appears stable for now, with the island enjoying a mutually positive relationship with hedge funds, things could turn ugly on short notice, and Puerto Rico could find themselves in a situation like Argentina.

While there have been some positive signs for the island, many investors are still waiting to see economic growth return. If Puerto Rico uses the 'grace period' provided to it by its hedge fund investors to kick-start growth, they should be able to transition back to typical municipal investors smoothly later on. That is exactly the type of soft-landing that the island is hoping for.