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Fund and Asset Manager Rating Group

U.S.A.

Big Changes for Puerto Rico Bond Market


Shift to New Investors Creates Bifurcated Trades
Crossover Buyers Bifurcated Motives: An increased number of hedge funds are now
trading Puerto Rico (PR) bonds; however, exposure to specific credits has bifurcated into two
groups those that support the commonwealths Public Corporation Debt and Enforcement
and Recovery Act (Recovery Act) and those that oppose it. Fitch Ratings estimates that there
are now over 60 alternative fund managers holding more than $16 billion of the islands debt in
aggregate, with some supporting the Recovery Act in order to ring-fence commonwealth
obligations from PR public corporations while others are suing to annul the Recovery Act.
Mutual Fund Exposure Concentrated: Overall, U.S. mutual fund ownership of PR bonds has
declined to 52%, but the remainder appears to be relatively concentrated, particularly in funds
managed by Oppenheimer and Franklin, who hold more than 35% of the $65.1 billion
outstanding. While most municipal fund net asset values (NAVs) have remained stable
following the interest rate stress of 2013, exposed Oppenheimer and Franklin funds
experienced NAV pressure in line with the exposure. The managers filed suit against PR,
alleging that the Recovery Act, passed on June 29, 2014, is unconstitutional.

Puerto Rico Bond Investement Base

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Related Research
Fitch: Chapter 9 Extension Would Be a
Positive for Puerto Rico (August 2014)
Fitch: Puerto Rico Bonds Decline Following
Recovery Act (July 2014)
Fitch Downgrades Puerto Rico GO, Sales Tax,
Retirement System & Water Revenue Bonds
(July 2014)
Fitch Downgrades Puerto Rico Electric Power
Auth's Rev Bonds; Maintains Watch Negative
(June 2014)
Puerto Rico Banks: Difficult Operating
Environment Constrains Ratings (May 2014)
Fitch: Investors Sell Puerto Rico Bonds;
PRICA Adds Uncertainty (February 2014)
Fitch: Rocked Puerto Rico Muni Bonds Hold
Tight (October 2013)

Analysts
Yuriy Layvand, CFA
+1 212 908-9191
yuriy.layvand@fitchratings.com
Ian Rasmussen
+1 212 908-0232
ian.rasmussen@fitchratings.com

www.fitchratings.com

Retail Investors,
$4 billion$7 billion, 8%

Pueto Rico Funds,


$6 billion, 10%
Puerto Rico IRA
Accounts,
$3 billion, 4%

Hedge Funds,
$15 billion$17 billion,
24%
Non-Fund Institutional,
$1 billion$1.5 billion,
2%

U.S. Closed-End Funds,


$3 billion, 4%

U.S. Oppenheimer and


Franklin Funds,
$23 billion, 35%
Other U.S. Mutual
Funds, $8 billion
$10 billion, 13%

Fitch-Rated Funds De-Risked Early: A review of 125 Fitch-rated municipal closed-end funds
with $68 billion in AUM across 14 large fund managers shows that they reduced their PR
exposure starting in summer and fall of 2013. Remaining exposure today is predominately with
Puerto Rico Sales Tax Financing Corporation (COFINA), general obligation (GO) and related
commonwealth credits, more than half of which are insured by monolines.
Retail Flows Sensitive to PR Exposure: Having the highest concentration, Oppenheimer and
Franklin municipal funds suffered more than $20 billion in net outflows since summer of 2013,
representing an average of 18% of their total May 2013 municipal fund AUM. In contrast,
cumulative flows across all other U.S. municipal funds averaged only 7%, indicating a lower
risk tolerance among retail investors and higher sensitivity to headline risk.
Bond Insurance A Factor: More than $23 billion of the outstanding PR bonds carry monoline
credit protection; for example, more than 50% of COFINA and the Puerto Rico Aqueduct and
Sewer Authority (PRASA) bonds are insured. While Fitch does not rate the bond insurers,
insurance can provide a secondary source of repayment.

August 13, 2014

Fund and Asset Manager Rating Group


Puerto Rico Bond Investor Base
(USD Bil.)
Type

Investors

PREPA

PRASA

PRHTA

Total

Traditional

Puerto Rico Funds

COFINA GO and Related


3.2

0.1

0.1

<0.1

6.3

Puerto Rico IRA Accts

1.4

1.3

<0.1

<0.1

<0.1

2.7

US Oppenheimer and
Franklin Funds

4.3

15.7

1.7

0.7

0.6

23

2.5 3

1 1.5

1.5 2

1 1.5

1 1.5

10 11

US Closed-End Funds

1.9

0.6

0.1

0.1

0.1

2.8

Non-Fund Institutional

< 0.1

< 0.1

< 0.1

< 0.1

1 1.5

Other US Mutual Funds

Alternative

Hedge Funds

Retail

Retail Investors

Total Bonds Outstanding

0.5 1.0

78

34

1.5 2

1.5 2

15 17

< 0.5

0.5 1.5

1.5 2.5

0.5 1

1 1.5

47

15.2

31.7

8.6

4.6

65.1

Data as of June 30, 2014 or latest available.


Source: The above figures are Fitchs approximations based on rated fund data, internal sources, and public filings. Figures account for bond issues only and exclude
the approximately $7.5 billion of outstanding shorter-term notes.

Funds Sell Out of Puerto Rico Leaving Exposures Concentrated


U.S. municipal funds have reduced their PR exposure by approximately 65%, on average,
since May 2013, according to a Fitch review of 125 rated municipal closed-end funds across 14
fund managers, which Fitch uses as a proxy for the broader $630 billion U.S. municipal mutual
fund market. A number of funds eliminated PR exposure entirely, while those with more of a
high yield focus maintained or even added bonds. However, two fund families maintained
material exposures. Together, Oppenheimer and Franklin owned over $23 billion, or 35%, of
the islands total issued bonds across various fund portfolios as of June 30.
PR passed the Recovery Act on June 29, 2014 to establish a restructuring regime for its public
corporations, an option that was not previously available to U.S. territories under the U.S.
bankruptcy code. The Recovery Act contemplates two procedures for public corporations to
address debt obligations in the event of insolvency. While they are intended to restore solvency
over the long term, both procedures entail debt restructuring that would trigger suspension of
debt payments and preclude the timely payment of principal and interest during the
proceedings. Entities covered by the act include Puerto Rico Electric Power Authority (PREPA,
$8.6 billion of debt outstanding), PRASA ($4.6 billion outstanding) and Puerto Rico Highway
and Transportation Authority (PRHTA, $5 billion outstanding), among others.
Reaction in the bond market was severe. Bond prices tumbled across PR issuers to historical
lows (see Fitch Research on Fitch: Puerto Rico Bonds Decline Following Recovery Act, dated
July 2014, available on Fitchs website at www.fitchratings.com, for observed price stresses).
Oppenheimer and Franklin funds filed suit in the U.S. District Court of Puerto Rico regarding
their PREPA holdings, alleging that the Recovery Act violates multiple provisions of the U.S.
Constitution, citing that the commonwealth has no power to enact its own bankruptcy law and
that furthermore, if enforced, it would inflict constitutional injuries on the bondholders that
violate the Fifth and Fourteenth Amendments. Fitch notes that PR GO and public corporation
bond prices have since recovered, while COFINA remains depressed.

Market Pivots to Hedge Funds as Bonds Grow Speculative


Related Criteria
Rating Puerto Rico Closed-End Fund
Debt and Preferred Stock (August
2013)
Rating Closed-End Fund Debt and
Preferred Stock (August 2013)

Big Changes for Puerto Rico Bond Market


August 13, 2014

Eager to capitalize on potential mispricing, hedge funds entered the market in bulk. Fitch
estimates that there are now more than 60 alternative fund managers holding between $15
million and $17 billion of bonds.

Fund and Asset Manager Rating Group


Fitch now sees a bifurcation hedge funds that hold PREPA, PRHTA and other public
corporation debt have joined Oppenheimer and Franklin funds suing to annul the Recovery Act,
while managers that bought COFINA, GOs and other related commonwealth credit formed the
so-called Ad Hoc Group (which now includes over 20 members with more than $4.0 billion in
holdings) to stand behind the commonwealth and provide support to ring fence obligations from
public corporations.
The rapid entrance of these investors has provided an observable floor in pricing for the
general obligation credit at $0.60 to 0.65 on the dollar for 30-year debt, with current values
having now recovered to the low $0.70s. Support is also evident in the falling cost of credit
protection in CDS contracts, which is now down by approximately 26% through the end of July.

Credit Default Swaps on Puerto Rico Debt


1 Year

(Cost of Protection, bps)

3 Year

5 Year

10 Year

2,500
2,000
1,500
1,000
500
0
7/13

8/13

9/13

10/13

11/13

12/13

1/14

2/14

3/14

4/14

5/14

6/14

Source: Bloomberg (with data provided by CMA).

Rated Closed-End Funds Remain Conservative on Puerto Rico


Fitch rated closed-end funds have already cut their holdings to the islands bonds following the
Detroit price contagion last year (see Fitch Research on Fitch: Investors Sell Puerto Rico
Bonds; PRICA Adds Uncertainty, dated February 2014, available on Fitchs website at
www.fitchratings.com). Generally, funds have not bought back into Puerto Rican debt since,
despite increasing yields from traded down prices. Fitch observes that June 30, 2014 portfolio
data show exposures continue to remain low and invested predominantly in COFINA, GO and
other commonwealth-related credits, where more than 50% of the bonds also carry bond
insurance.

Puerto Rico Bonds Held by Fitch-Rated Closed-End Funds


Cofina

GO

(Aggregate USD Million Par)


1,000

PRASA

PREPA

PRHTA

884

900
800
700
600

556

500
400

333

300
200
100

125
25

18

22

61

0
Uninsured

Insured

Source: Fitch. Data based on holdings across 125 Fitch-rated municipal closed-end funds with $68 billion in AUM managed
across 14 fund managers (Nuveen, Invesco, Neuberger Berman, Deutsche, Dreyfus, Blackrock, Western Asset, Mainstay, MFS,
Pioneer, Federated and Duff & Phelps).

Big Changes for Puerto Rico Bond Market


August 13, 2014

Fund and Asset Manager Rating Group


The uninsured PR bond exposure constituted an average of 2% of the advisors closed-end
fund assets based on par and 1.5% based on portfolio market values, whereas insured
exposure was on average 1% of par and 0.70% of market value.
Given the small exposure, Fitch does not expect volatility in PR bond prices to have a
meaningful impact on fund NAVs or overcollateralization levels supporting the fund-issued debt
rated by Fitch. Furthermore, leverage ratios in rated funds ranged from 35%40%, providing
ample cushion to the funds covenanted leverage triggers.

Bond Insurance May Provide Alternative Repayment


Approximately $23.6 billion, or 36%, of the PR bond market is insured by one of the monoline
bond insurers, according to a Fitch market review. Ambac, Assured and National Guaranty
were the biggest players noted, with FGIC, Syncora, Radian and ACA insuring only a few
legacy issues. The coverage varied widely based on perceived credit risk and insurance pricing
at the time of bond issue. For example, 75% of all PRHTA bonds carried insurance, while the
figure was only 30% for PREPA and 0% for PRASA. See the chart below for full analysis.
Insured bonds have remained an area where mutual funds have remained invested in Puerto
Rican debt. For example, the 125 Fitch-rated municipal closed-end funds have only 1.9% of
portfolio market values in PR bonds (or 2.6% of par), but 54% of this exposure was insured.
The value of this insurance ultimately depends on the financial strength of the provider, many
of whom were severely impaired by the financial crisis. At present, Fitch does not rate the
monoline bond insurers covering PR.

Monoline Insurance of Puerto Rico Bonds


Uninsured

45

Ambac

Assured

National

Other

(USD Billion of Bonds


Outstanding)

Insured % (RHS)

(% of Outstanding Bonds
Insured)

40
35
30
25
20
15
10
5
0
COFINA

GO

PREPA

PRASA

100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%

PRHTA

Note: Other includes FGIC, Syncora, Radian, ACA and others.


Source: Fitch, public data.

Big Changes for Puerto Rico Bond Market


August 13, 2014

Fund and Asset Manager Rating Group

Retail Investors Flee Puerto Rico Laden Funds


Retail investors have shown a lower risk tolerance and a higher sensitivity to headline risk
surrounding the credit. U.S. funds that invested heavier in PR bonds experienced greater
outflows since May of 2013 than the rest of the sector. For example, Franklin and
Oppenheimer funds, which carried higher than average PR exposures, experienced net
outflows of 18% or $20.5 billion, respectively, compared with an average of 7% net outflows for
the rest of mutual funds in the municipal sector.

Municipal Fund Flows Since May 2013


(% AUM)

Oppenheimer

Franklin

Other Municipal Mutual Funds

2
1
0
(1)
(2)
(3)
(4)
(5)
(6)
5/13

6/13

7/13

8/13

9/13

10/13

11/13

12/13

1/14

2/14

3/14

4/14

5/14

Source: Fitch, Lipper.

Big Changes for Puerto Rico Bond Market


August 13, 2014

Fund and Asset Manager Rating Group

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Big Changes for Puerto Rico Bond Market
August 13, 2014