(Bloomberg) -- Puerto Rico debt is rallying the most in two years, even under the threat of a cut to junk, as the commonwealth prepares to sell bonds for the first time since August.
The debt has returned 3.1% in January, beating all U.S. states in a Standard & Poor’s index. The gain follows a 4.9% tumble in December as yields soared to record highs, luring hedge funds and distressed-debt buyers. Sales-tax bonds ranked four steps below AAA and maturing in August 2037 traded Jan. 28 with an average yield about 1.5 percentage points above an S&P index of junk-grade munis.
Even after lawmakers trimmed pension benefits, raised taxes and shrank budget gaps, the territory of 3.6 million risks losing its investment-grade ranking, potentially curbing the pool of buyers for its debt. About 70% of U.S. mutual funds that focus on city and state bonds own Puerto Rico securities, which are tax-exempt nationwide, according to Morningstar Inc.
“Time is of the essence here because the rating agencies have given them a deadline and there’s only so much they can do,” said Robert Amodeo, head of munis in New York at Western Asset Management Co., which manages $28 billion in local debt.
S&P threatened last week to cut Puerto Rico’s debt to junk within 90 days if it’s unable to access capital markets. Moody’s Investors Service issued a similar warning Dec. 11.
Puerto Rico and its agencies, with $70 billion of debt, and other lower-rated issuers are benefiting from rising demand with investors adding the most money to high-yield muni mutual funds this month since September, according to U.S. Lipper Fund Flows data. Average yields on Puerto Rico general obligations maturing July 2041 climbed to a record 9.29% on Dec. 30.
The January gain in Puerto Rico debt is the most since a 3.7% rally in January 2012, S&P data show. The $3.7 trillion market for municipal debt has returned 2.2% this month. The gains have driven benchmark 10-year yields to 2.6%, the lowest since June, according to data compiled by Bloomberg.
Officials plan to sell long-term debt next month to balance budgets after rising interest rates last year hindered the issuance of bonds backed by sales-tax revenue. Those securities have the highest rating among the island’s credits.
The last commonwealth issuer to sell debt was the Puerto Rico Electric Power Authority, which offered $673 million of revenue bonds in August.
Results of the planned sale may influence Puerto Rico’s ratings and help investors value the island’s securities in the secondary market, said Troy Willis, senior portfolio manager in Rochester, New York, at OppenheimerFunds Inc., which oversees about $28 billion of munis.
“That’s going to dictate a lot on how the market and rating agencies react,” he said.
The Government Development Bank, which handles the commonwealth’s debt transactions, declined to comment, Alix Anfang, a spokeswoman in New York, said in an e-mail.
Commonwealth sales-tax bonds with an A+ grade from S&P and maturing in 23 years traded today with an average yield of about 8.14%, or 4.43 percentage points above benchmark munis, Bloomberg data show. The debt yielded 8.7% at year-end, for a spread of 4.6 percentage points.
The yield still eclipses interest rates on lower-rated munis. Non-rated or speculative-grade munis with an average maturity of 20 years yielded about 6.6% as of Jan. 28, according to S&P data.
Commonwealth officials have raised taxes and fees and limited spending to reduce deficits as they seek to reassure bondholders they will repay their obligations, said Willis at OppenheimerFunds.
“Most corporate borrowers don’t have the ability to both increase revenues and decrease costs at the same time,” Willis said. “I don’t need big growth in order for them to pay off their debt. I just need stabilization, and I think they’ve been able to achieve that in the last couple of years.”
Governor Alejandro Garcia Padilla, of the Popular Democratic Party, who took office a year ago, has said the island will repay its debts on time and in full.
Puerto Rico will need to market its debt to a more limited group of investors because credit concerns are leading individuals and some mutual funds to hold off, David Hitchcock, an S&P analyst, said in an interview. Investors such as hedge funds, which don’t buy Puerto Rico debt for its tax benefits, may show interest, Hitchcock said.
Puerto Rico officials were set to meet with the major credit-rating firms this week to discuss the island’s finances, Maria Quintero, spokeswoman for Treasury Secretary Melba Acosta, said in a statement.
If Puerto Rico were cut to speculative grade, it would have to pay as much as $1 billion for collateral and accelerated payments on swaps and other financings, Lisa Heller, a Moody’s analyst, said in a Dec. 11 report.
High-yield, high-risk bonds are rated below Baa3 by Moody’s and lower than BBB- at S&P.
If one or more of the rating companies cuts the island to junk, “we will act responsibly and we’ll take additional actions,” Acosta said Jan. 24 in an interview on CNBC. “We are prepared for an event like that.”
Island governors have been borrowing to balance budgets as the economy has struggled to grow since 2006. Puerto Rico’s 15.4% December unemployment rate was the highest in two years.
“It really should not come as a surprise if they are marked to junk,” Amodeo said. “The marketplace has priced in most, if not all, of that downgrade.”