11-1-13 11:04 AM EDT | Email Article

By Ben Eisen, MarketWatch


NEW YORK (MarketWatch) -- Puerto Rico municipal bond prices have been falling at a startling pace this year, sent skidding by investors jittery over the U.S. territory's financial straits and a weak market environment. But signs are emerging that the island's tax-exempt bonds may have reached the bottom.


In October, Puerto Rico debt got some much-needed price support as investors entered the market, pushing the S&P Municipal Bond Puerto Rico index to a monthly gain of 1.69%, the largest gain since April. The value of the index, which tracks a broad variety of the island's bonds, has declined more than 17% in the last twelve months, a rare fall in a market generally known for its stability.


Puerto Rico has roughly $70 billion in muni bonds outstanding, and because they are exempt from federal, state, and local taxes, they have long been held in an array of U.S. investment portfolios. The island, meanwhile, has faced severe budget deficits, unfunded pension liabilities, slowing economic growth, and tight cash flows that have pushed it to the lowest investment-grade credit rating category.


As the broad municipal bond market sold off this summer, attention turned toward perpetually-struggling Puerto Rico, with questions arising over whether the island would default on its bonds. A cover story by Barron's on the island's woes gave investors reason to exit the market, and the selling pressure snowballed as local bondholders and international buyers liquidated their positions.


"The fuse got lit by the Barron's article in August," said John Mousseau, executive vice president and the director of fixed income at Cumberland Advisors, which does not own Puerto Rico bonds. "It pointed out the danger of all funds trying to get out through the revolving door at once."


Puerto Rico bonds contain many substantial and well-publicized risks, not least of which is an outright default on the debt. But where there are sellers, there are also buyers. Hedge funds have been the most prominent entrants to the market, but other types of investors are finding a range of reasons to buy up the bonds.


"We believe they can manage their debt load," says David MacEwen, chief investment officer of fixed income at American Century Investments, which has picked up Puerto Rico debt on the cheap.


Fiscal bleeding is slowing


Though the island's bonds have sold off in recent months, the decline in price has not been connected to a large-scale change in its financial position. Often forgotten among the negative headlines is that the island's government is taking steps to address its fiscal situation, including raising its revenues, making its public financing corporations self-sufficient, and reforming its pension system. Government officials outlined those steps to investors in October.


Puerto Rico has a long way to go to stop the bleeding, as well as position the economy to make it more competitive. One estimate, for example, pegs Puerto Rico's pension system at 8% funded, with 45% of the population living below the poverty line. Nonetheless, the efforts undertaken by government officials to fix legacy problems have been recognized by some analysts and investors.


"I think they are doing the right thing. They are doing more than anyone else has done to date," said David Tawil, co-founder of Maglan Capital, a distressed investing firm that has been buying up Puerto Rican debt. He notes, however, that the government's projections should be taken with a grain of salt.


Puerto Rico issues a diversified set of bonds, some backed by specific revenue streams not tied to the government's general fund. Sales-tax-backed bonds, for example, fall into that category and are thought to contain less risk.


Tough to let Puerto Rico fail


When Detroit filed for bankruptcy in July, the federal government largely declined to become involved in the case. While some assistance was provided, the city was left to its own devices in the bankruptcy court as it attempts to provide haircuts to bondholders as part of the restructuring process.


But Puerto Rico isn't comparable to Detroit. Unlike in Motown, Chapter 9 of the bankruptcy code doesn't permit Puerto Rico to file for bankruptcy if its financial situation worsens, which means that a failure of the island to make good on its bonds wouldn't lead to an organized restructuring process.


More likely, it would lead to mayhem, with no system for the debtor and its creditors to negotiate a solution, says Tawil of Maglan Capital. Further, Puerto Rico debt makes up a substantial portion of the municipal bond market, so a default could create systemic ripples throughout the market.


"The possibility is that it would descend into chaos," says Tawil, who has been buying Puerto Rico bonds at discounted levels. Part of the reason he's buying is that he thinks a default would create such a dire situation that there's no way the federal government would let it happen.


"If they couldn't access the market, I think Washington would throw them some breathing room," he said.


The Treasury Department has denied that it has immediate plans to assist Puerto Rico, but discussions between officials on the island and in Washington are said to have taken place. The issue of whether and how the federal government would step in has become a popular subject of debate across the municipal market.


Hedging the risk


If, in a worst-case scenario, the Puerto Rico bonds defaulted, one way to protect against losses is by taking the other side of the bet that Puerto Rico will pay up. It's not possible to short municipal bonds, but you can short the insurer of the bonds.


Mousseau and his colleagues at Cumberland Advisors premised that an investor could buy Puerto Rico general obligation bonds insured by the largest agency guaranteeing the island's debt, Assured Guaranty Corp. (AGO). The investor could at the same time short Assured's stock or buy credit default swaps, which are seen as insurance against a default by Assured.


If Puerto Rico defaulted, and that in turn brought down the bond insurer, the investor would get a payout on the short position or on the CDS.


"The theory behind this is that Assured Guarantee would be hurt if Puerto Rico defaults," said David Kotok of Cumberland Advisors in a note this week. "So, the hedge fund's long position would lose from a Puerto Rico debt downgrade or default, but it would have an offsetting gain from the credit default swap position or short position on Assured Guarantee stock."


Puerto Rico bond prices have tended to move in line with Assured's stock, says Kotok. The bond prices also move inversely to the cost of Assured Guaranty CDS. That implies the outcome of Puerto Rico impacts the outcome of Assured.


Nonetheless, this strategy is no sure bet, and it's not for the faint of heart, writes Kotok, who does not recommend buying Puerto Rico debt. Given that, the best strategy may be to proceed with caution.


"We think there is additional headline risk of trouble in Puerto Rico," he writes. "There is risk of a debt-service-payment miss in the event that Puerto Rico finds itself with insufficient cash flow to meet debt-service payment; and there is market risk if the Commonwealth fails to obtain sufficient market access so that it can roll the debt."

-Ben Eisen; 415-439-6400; AskNewswires@dowjones.com


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(END) Dow Jones Newswires

11-01-13 1104ET

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