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The Bond Buyer
Bondholders Not Concerned By Recent Puerto Rico Downgrades
By Christine Albano
31 May 2005
The Bond Buyer
WASHINGTON -- Large institutional holders of Puerto Rico debt say they are not overly concerned with the recent downgrades of the commonwealth's general obligation debt, and say that upcoming deals planned by the island government should face few hurdles stemming from the negative rating action when they enter the market later this year.
Puerto Rico paper typically trades at tight spreads to national scales due to the strong demand for its universal acceptance and double exemption, fund managers said.
"The downgrades were obviously significant, but Puerto Rico still has the advantage of being tax-exempt everywhere, so I think there'll continue to be pretty good demand for the name," said Clark Wagner, portfolio manager at First Investors Management Co. in New York City. He owns Puerto Rico debt totaling $1.6 billion in each of the several single-state funds and three national funds he manages.
The newest sale to test the market's appetite following the downgrade will be this week's sale of at least $500 million of special tax revenue bonds from the Puerto Rico Infrastructure Financing Authority.
The deal, which is rated Baa2 by Moody's Investors Service and BBB-plus by Standard & Poor's, is expected to be priced on Wednesday by UBS Financial Services Inc. with a structure that contains capital appreciation bonds maturing from 2029 to 2035, as well as current interest term bonds in 2037 and 2041, according to the i-Deal LLC negotiated calendar.
A UBS banker did not return calls seeking comment on the structure and possibility of credit enhancement, and officials at the underwriting desk said details about the deal were unavailable late last week.
Market sources have indicated the deal could also include up to $500 million of refunding bonds.
Ahead of the IFA deal, traders last week said there has been moderate activity on Puerto Rico paper in the secondary market in the wake of the two downgrades of the commonwealth's GO debt.
Last week, Standard & Poor's downgraded the GOs to BBB from A-minus, a move that was preceded by a downgrade from Moody's, which two weeks ago delivered its first change to the commonwealth's GO debt in more than 25 years when it dropped the rating to Baa2 from Baa1. The GO debt and the IFA now have the same underlying rating from Moody's.
The agencies cited a weakening general fund, highlighted by a $1.3 billion deficit, an increase in tax-supported debt and a decline in liquidity of Puerto Rico's Government Development Bank as some of the main reasons behind the territory's declining credit quality.
In a related move, the downgrade of the commonwealth triggered additional negative action from Moody's last week when it placed the University of Puerto Rico's A3 bond rating for senior debt, and its Baa1 rating on subordinate debt on its watch list for possible downgrades.
On Friday, Standard & Poor's also lowered its underlying rating on the University of Puerto Rico to BBB from A-minus. In addition, the agency lowered its underlying rating two notches to BBB-minus from BBB-plus on the Puerto Rico Industrial, Tourist, Educational, Medical, and Environmental Control Facilities Financing Authority series 2000A bonds, issued for the University of Puerto Rico for the development of Plaza Universitaria. Analysts said the outlook is negative.
The university's ratings are in jeopardy, according to Moody's, due to the substantial support it receives from the commonwealth itself. The A3 ratings apply to $440 million of outstanding bonds, while the Baa1 rating applies to $86 million of outstanding debt.
Fund managers said upcoming new deals from the commonwealth should be as well received as they have in the past - despite the GO downgrades - however, they may have a more difficult time securing insurance because of the negative rating actions.
The IFA deal will be the first to be priced in the new-issue market since the downgrades, but certainly will not be the last this year.
The island government plans to make repeated trips to the municipal market later in 2005 in what will be its most active issuance cycle since 2001, when it issued nearly $3 billion in new-money and refunding GOs. One of the larger deals expected in the second half of this year is a $2 billion pension obligation bond issue, followed in size by a $575 million GO sale from the Government Development Bank, and a $300 million sale from the Puerto Rico Municipal Finance Agency. Other financings include two separate deals for a coliseum and a convention center totaling about $100 million.
Tom Abruzzo, a managing director in the financial guarantors group at Fitch Ratings, said insurers usually assign relatively more capital to back a municipality with a lower credit rating.
"Lower ratings could make it a little difficult, and at a minimum, it would make it more costly," he said. "The lower the rating, the more capital needs to be assigned to those obligations."
Abruzzo said an insurer's capital requirements are based on the underlying ratings of potential clients. "Bond insurers have to put up more capital to insure those lower-rated credits and municipalities," he added.
In the case of Puerto Rico's full faith and credit pledge, the bonds still appear to be in the investment-grade category, he pointed out.
"It is still an eligible issuer for a bond insurer to wrap," Abruzzo said. "If a rating falls below investment-grade then it's usually not eligible for the triple-A insurers." Fitch does not have underlying ratings on Puerto Rico's GO bonds.
At the same time if an insurer declines to pursue a new Puerto Rico issue, Abruzzo said, it could be because it has reached its capacity for insuring that particular credit or municipality.
"Puerto Rico is a commonwealth that most of the bond insurers have a pretty sizable exposure to," he noted. If they pass on an upcoming deal, he added, "it might not necessarily be because of a recent rating action."
Whether or not the IFA deal comes to market insured, it should still find buyers, institutional investors said. If it provides the added comfort of insurance, it will be especially appealing to risk-averse retail investors.
"If it's insured it probably will have a pretty strong retail showing, but if not, it's questionable" how much retail appetite there will be for the deal, said Dan Loughran, a vice president and portfolio manager at OppenheimerFunds Inc. in Rochester, N.Y.
On the other hand, if it offers extra yield by virtue of being uninsured, that will be a welcome sight for those looking for attractive buying opportunities at a time when the market is suffering from low absolute yields, the managers pointed out.
Loughran is among the fund managers that would prefer to see the IFA deal come uninsured and at relatively cheap levels to entice buyers to such a large offering, given the market's low absolute yields and the commonwealth's current fiscal crunch.
"A large deal that is insured is less exciting for us," he said. "We like to take on credit risk as long as we're paid for it." Loughran is part of team that manages 10 funds totaling $17.5 billion.
He said while there is strong demand for Puerto Rico paper in general, the commonwealth still has some major clouds hanging over its head.
"The main thing is there is structural imbalance and no plans to fix it," Loughran said. "They don't have a firm plan for addressing their fiscal imbalance, no budget, and no great ideas on how to cut costs and increase revenues."
As a result, the new IFA deal, he said, "has to be cheaper than where it would have come before the downgrade."
"Where yield levels are right now, it's not overly compelling to invest long term at these types of market yields," Loughran added.
Other managers, like Wagner, agreed, and said an uninsured IFA deal would jumpstart a bland market.
"People might just welcome the additional yield on uninsured bonds in this environment, although I'm not sure how much more yield the downgrades will provide," Wagner said.
Although he owns very little of the GO debt and more of other Puerto Rico paper, like electric and highway revenue bonds, Wagner said the presence of a fresh name should be a strong selling point for buyers in general.
"We are not real active right now because of where rates are and we are not getting a lot of cash into the funds," he said. "But the fact that it's a different name would make it ultimately more appealing."
Overall, players say the downgrades of the GO debt are not as damaging as when a credit goes from investment grade to junk status, and therefore the IFA deal and those that follow it should receive a warm welcome.
"I would think that going from Baa1 to Baa2 is probably not going to affect that many portfolio managers in the sense that [the commonwealth] had been on credit watch and their fiscal problems were well known," said Greg Serbe, president of Lebenthal Asset Management in New York City.
Other institutional investors agreed that the downgrades were not surprising given the recent difficulties that Puerto Rico has had in cutting costs, increasing revenues, and other fiscal deficiencies which have contributed to it coming narrowly close to adopting a 2006 fiscal year budget before the June 30 deadline.
Despite the financial troubles, fund managers say they are comfortable with its underlying credit quality and are holding on to existing bonds in their portfolio because a significant amount of Puerto Rico debt sold in recent years has come to market insured.
That provides a second line of defense and helps curtail concerns over the underlying credit quality, managers said.
"You are not going to lose sleep if [the GO debt] goes to Baa2 from Baa1 because you already have the insurer on your side," Serbe continued. "If you were already comfortable with its [financial] issues, I suspect that would not deter [investors] from buying it."
Municipal traders said they originally anticipated seeing an excessive amount of Puerto Rico paper flooding the secondary market following the downgrade of the GOs, but the volume has instead been fairly manageable.
Amid the moderate trading of several different Puerto Rico names, one of the most recent trades that took place early last week involved the 5% coupon bonds due in 2035 from an insured, $993.4 million Puerto Rico Electric Power Authority issue that was priced on March 22 and was the sole Puerto Rico deal to be priced since the beginning of the year.
On Wednesday, the 2035 bond was trading at a 3.91% yield to the 2015 call, according to Municipal Securities Rulemaking Board trade data on The Bond Market Association's Web site, investinginbonds.com.
When the new issue was priced, the 2035 term bond was originally priced to yield 4.48% - 12 basis points richer than the 30-year triple-A GO scale published by Municipal Market Data at the time of the pricing. The 30-year triple-A GO bond was yielding 4.29% on Friday, according to MMD.
"The spreads are generally very tight [to the national GO scale] based on the tax-exemption and the supply," Wagner said. "There has not been a lot of Puerto Rico paper in the secondary market recently, so there is usually pretty good demand for [new] deals when they come."
The upcoming deals from Puerto Rico issuers should be able to be absorbed by the market, but it might require a little more effort to get sold, according to Denis Galle, a municipal trader at Advest Inc., a division of AXA Financial Inc. in New York City.
New deals from Puerto Rico might take a little more time - and extra yield - to get sold compared to the electric power authority deal, which was "pretty well placed and absorbed pretty quickly," he said.
"There may be a little more overhang than average, since the downgrade eliminated some buyers here and there," Galle said. "Some institutional buyers need a certain underlying rating and a Baa2 just knocks them out" of the picture, he added.
The IFA deal should be priced to sell, according to traders and institutional investors. They said that underwriters will want to take advantage of the deal occurring on June 1 - traditionally one of the heaviest redemption dates of the year when a significant amount of cash from coupon payments and called or maturing bonds usually flows into investors' accounts.
"Puerto Rico is recognized all over the country and it will be the first time that an issuer comes to market since the downgrade," Galle said. "We will have to see how it is perceived by the buyers." (c) 2005 The Bond Buyer and SourceMedia, Inc. All rights reserved. http://www.bondbuyer.com http://www.sourcemedia.com