(Bloomberg) -- Pacific Investment Management Co. and BlackRock Inc. say the entire $3.7 trillion municipal market is at risk should Puerto Rico lose its investment-grade status, even though many funds aren’t obliged to unload bonds cut to junk.
Bondholders got a reminder this week that the commonwealth’s credit rank is in jeopardy. The extra yield investors demand on Puerto Rico debt set a one-month high after Fitch Ratings threatened to lower the Caribbean island to junk by June 30 if it is unable to borrow through financial markets. Puerto Rico is also one step above speculative grade from Standard & Poor’s and Moody’s Investors Service.
With more than three-quarters of U.S. muni mutual funds holding Puerto Rico debt for its tax benefits, fund companies like Pimco and BlackRock are studying the ripple effect of a descent into junk. Such a step may frighten off the individual investors who dominate the local market, pressuring funds to sell debt to generate cash, said Joe Deane, head of munis at Pimco, which runs the world’s biggest bond fund, and Peter Hayes at New-York based BlackRock.
“There would have to be some selling,” said Hayes, who oversees $108 billion as head of munis at BlackRock, the world’s largest asset manager. “It’s just a matter of who would buy the bonds that come out to be sold and at what price.”
The self-governing commonwealth of 3.7 million, struggling with a contracting economy, has a negative outlook on its bonds from all three major rating companies. The territory and its agencies had $70 billion of debt as of June 30, according to the island’s Government Development Bank, which handles capital- market transactions.
The territory’s bonds, which are tax-exempt nationwide, have lost about 16 percent this year, more than seven times the decline of the municipal market as a whole, Standard & Poor’s data show.
If Puerto Rico were cut to junk, investors may relive losses seen in the three months through August because mutual funds would turn to easier-to-sell munis with higher ratings to meet redemptions, said Deane. The municipal market lost 5.5 percent in the three months through August, the steepest decline since 2008.
“If Puerto Rico were to have further problems accessing the market or a downgrade, obviously it will put some pressure on the funds that own that,” said Deane, who’s based in New York. “In all likelihood, they’ll sell what they can and not what they should.”
Pimco, which is based in Newport Beach, California, and is owned by Munich-based insurer Allianz SE, managed $1.97 trillion as of Sept. 30. It has had no allocation to Puerto Rico in its tax-free funds for seven months, Deane said.
Puerto Rico officials said on a webcast last month that they had sufficient funds to forgo selling debt before June 30 if interest rates are too high.
At least 60 prospectuses of the 180 muni funds that direct 5 percent or more toward commonwealth securities don’t require selling Puerto Rico debt if the island were cut to junk, according to an Oct. 31 report from Height Securities LLC, a Washington-based broker-dealer.
Yields have already risen from earlier this year, helping mitigate losses for muni mutual funds if Puerto Rico were lowered to junk, said Daniel Hanson, a Height analyst.
Puerto Rico general obligations maturing July 2041 traded this week with an average yield of 8.2 percent, or 4.1 percentage points above benchmark munis, the biggest yield spread since Oct. 21, data compiled by Bloomberg show.
“Some of the loss may already be baked in,” Hanson said.
Yields rose from June to August as investors pulled cash from muni mutual funds on speculation that the Federal Reserve will scale back its bond buying. Detroit’s record bankruptcy filing in July and concern that Puerto Rico’s finances would deteriorate fueled more withdrawals.
Even though most funds aren’t required to sell debt that’s cut to junk, investors would yank money in response to such a step for Puerto Rico because it might signal more stress ahead for the island, Hayes said. He said he anticipates the island may have its rating reduced to junk as soon as mid-2014.
“Investors are going to take that as a perception that there’s more bad news coming,” Hayes said.
BlackRock has decreased Puerto Rico to about 0.08 percent of muni holdings, Hayes said. Debt of the commonwealth and its agencies take up 2.6 percent of Barclays Plc’s muni index. If yields were to increase, the company would evaluate the debt for a possible purchase, Hayes said.
Governor Alejandro Garcia Padilla, 42, who took office in January, wants to bring the commonwealth out of recession and end recurring budget deficits by fiscal 2016. The island’s August unemployment rate was 13.9 percent, compared with 7.3 percent nationwide.
Puerto Rico Treasury Secretary Melba Acosta and Government Development Bank Chairman David Chafey declined to comment.
The island’s economy is projected to shrink 0.8 percent in the year through June 30, according to Puerto Rico’s Planning Board. Yet the commonwealth collected $120 million more revenue in the four months through October than budgeted, according to preliminary results from the island’s Treasury Department.
New York-based OppenheimerFunds Inc. and Franklin Resources Inc., based in San Mateo, California, are some of the biggest holders of Puerto Rico securities, according to Morningstar Inc.
“The recent data coming from the island supports our belief that Puerto Rico is an improving credit,” Daniel Loughran, an OppenheimerFunds portfolio manager, said in an e- mail.
Stacey Johnston Coleman, a Franklin spokeswoman, referred to an Oct. 22 video on the firm’s website.
“While we feel Puerto Rico is facing a difficult situation, we feel that their bonds are being unjustly punished,” Rafael Costas, co-director of Franklin’s muni department, said in the video. “We are still talking about an investment-grade rated issuer that happens to be trading at distressed levels.”
Elsewhere in the market this week, localities plan to sell about $8 billion of long-term debt with yields close to a one- month high.
Top-rated 10-year munis yield 2.82 percent, compared with 2.7 percent on similar-maturity Treasuries.
The ratio of the interest rates, a measure of relative value, is about 104 percent, compared with a five-year average of 102.5 percent. The higher the figure, the cheaper munis are compared with federal securities.
Following is a pending sale:
Maryland’s Transportation Department plans to sell $250 million of tax-exempt revenue debt through competitive bid on Nov. 20, Bloomberg data show. Proceeds will finance highway repairs and improvements, according to Moody’s.