Ratings on short- and medium-term notes issued by Puerto Rico municipal bond funds remain stable despite severe price volatility in the island’s municipal market, Fitch Ratings service said Thursday.
“Stability in ratings has been helped by sufficient overcollateralization at the rated sub-account level within the fund and prudent portfolio management. We expect ratings will remain stable given the tight deleveraging triggers in place to protect noteholders from further collateral erosion but are mindful that excess volatility in pricing could hurt the rest of the portfolio and depress fund net asset values (NAVs) further,” the New York-based credit ratings agency said in a statement.
The Puerto Rican bond selloff that started in late August follows an already deep price stress experienced in the broader municipal market, it noted.
“Bond prices on top Puerto Rican debt fell to below $0.65 on the dollar, and yields spiked closer to 9 percent as of Oct. 15, 2013, according to the Municipal Securities Rulemaking Board. Total assets managed by the major Puerto Rico mutual funds lost $6 billion toward the second week of October from the $13 billion they managed in May 2013,” Fitch noted.
Recent price pressure has caused severe NAV erosion for the Puerto Rico funds and, at times, forced asset sales.
However, Fitch said funds have benefited to the extent they held U.S. agency mortgages and non-Puerto Rico municipal bonds for liquidity but took big haircuts when needing to sell Puerto Rico bonds.
“Local PR municipal obligations (non-103 bonds) initially traded wider, but the pricing converged as PR municipal bonds originally sold to U.S. fund companies (103 bonds) experienced strong selling pressure in the U.S. market,” it said.
During the period of late August through early October, many Puerto Rico funds took advantage of the 5 percent additional borrowing capacity that funds can utilize for temporary, emergency or defensive purposes beyond the standard 50 percent fund-level leverage cap set forth in the prospectus of each fund.
More recently, the Office of the Financial Institutions Commissioner issued rulings to each fund manager that waived even this deleveraging limit, which ultimately may be a benefit for funds’ common shareholders if asset prices rebound, but added credit risk to the funds’ repo and margin lenders from the shrinking collateral base.
“Rated notes issued by these funds were unaffected, as the relevant fund sub-accounts supporting the notes operate at leverage levels consistent with Fitch’s ‘A’ and ‘AA’ ratings criteria,” the agency said.
Many U.S. mutual funds slashed their holdings of the island’s bonds by more 20 percent from end of May to end of August, per Fitch data, while some fund managers removed their exposure entirely anticipating the price contagion effects of the Detroit bankruptcy.
“Noise on the street also caused financial advisors to stop recommending Puerto Rico bonds to their investors altogether, which further depressed asset prices. Opportunistic investors have purchased bonds at current depressed levels, with over $1 billion traded in such activity over the past few weeks, but so far this has not translated into a meaningful price pickup,” Fitch concluded.