High-Yield Muni Market Passes a Key Test From Puerto Rico’s Sell-Off

(Bloomberg) -- Over the past month, hedge funds and other investors dumped more than $2.5 billion of debt they received in Puerto Rico’s record restructuring, a sell-off that made the sales-tax-backed securities the most actively traded in the municipal-debt market.

Yet the prices haven’t crashed -- and the flood did little, if anything, to dampen the gains for other tax-exempt junk bonds.

The performance shows that the $3.8 trillion municipal market weathered a major test from Puerto Rico’s bankruptcy, by far the biggest ever for an American government. The debt restructuring, a precursor of others that will follow, had raised concern that the speculative corner of the market would struggle to absorb the billions of dollars of new debt, pushing up yields on Puerto Rico’s new securities and other high-risk debt competing for limited space in investors’ portfolios.

“If investor demand remains strong, new issuance remains light and hedge funds remain disciplined sellers, the Cofina exchange suggests the market will be okay and relationships within the market will remain stable,” said Guy Davidson, who helps oversee $42 billion of state and local debt as director of municipal investments at AllianceBernstein.

The new batch of restructured debt hit the secondary market in February after Puerto Rico issued $12 billion of non-rated sales-tax bonds, called Cofinas, to investors who traded in their outstanding securities, cutting more than $5 billion of the island’s troubled debt. Since then, high-yield municipals have earned 1.2 percent, more than the 0.8 percent advance in the broader tax-exempt market, according to Bloomberg Barclays indexes.

The response reflects the demand for securities with higher yields, according to Robert DiMella, co-head of MacKay Municipal Managers. Investors have added $4 billion this year to muni funds specializing in riskier debt, according to Lipper US Fund Flows data, providing a steady flow of cash to snap up securities traded in the secondary market.

So far, the re-entry of Puerto Rico hasn’t affected high-yield municipals because those funds have seen strong inflows this year, DiMella said. “They haven’t had to sell any of the other sectors to buy Puerto Rico yet.”

Puerto Rico is seeking to restructure more of its debt, including $17.8 billion of general obligations and commonwealth-guaranteed securities, and another $9 billion of its electric company’s debt. Once the bankruptcy is over, Puerto Rico’s restructured bonds may eventually account for 22 percent of the high-yield municipal market, according to Davidson.

Hedge funds that are major owners of Puerto Rico bonds will be looking to eventually sell their restructured bonds to mutual funds and long-term tax-exempt buyers who shunned or drastically cut their exposures to the island after its financial crisis worsened.

Sell Options

Investors may opt to sell tobacco bonds -- one of the most liquid type of high-yield debt -- to buy Puerto Rico’s restructured securities, said Lyle Fitterer, head of municipal fixed income for Wells Fargo Asset Management, which oversees $38 billion of state and local government debt, including a “small portion” of the new Cofinas.

“You could see some guys who traditionally bought tobacco -- or are heavy into tobacco -- who could look to diversify out of that space because the fundamentals there seem to be deteriorating a bit,” Fitterer said.

OppenheimerFunds Inc. and SEI Investments Fund Management held the new Cofina bonds, as of Feb. 28, Bloomberg data show. Other investors include municipal-bond ETFs such as VanEck Vectors High Yield Municipal Index ETF and SPDR Nuveen S&P High Yield Municipal Bond ETF, Bloomberg data show.

Prices on some of the new Cofinas have dipped since the debt first began trading amid the heavy pace of selling. Bonds maturing in 2058 with a 5 percent coupon, the most actively traded, changed hands Tuesday at an average price of 94.5 cents on the dollar, down from an average 97.5 cents when the bonds first started trading on Feb. 15, Bloomberg data show.

The risk of yields rising on junk-grade municipal debt may ultimately have nothing to do with Puerto Rico, Fitterer said. An economic downtown would have a greater impact, he said.

“I’m more concerned about muni high yield because of other things than I am about Puerto Rico,” Fitterer said. “If we do head into a recession, you start to see defaults occurring, credit spreads naturally go wider."

--With assistance from Amanda Albright.

To contact the reporter on this story: Michelle Kaske in New York at mkaske@bloomberg.net

To contact the editors responsible for this story: James Crombie at jcrombie8@bloomberg.net, Michael B. Marois, William Selway

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