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Debt Investors Shrug Off Puerto Rico Downgrade

NEW YORK (The Deal) -- After weeks of speculation, Standard & Poor's has downgraded the Commonwealth of Puerto Rico's general obligation debt to a junk rating ahead of the island's planned debt offering, but municipal investment sources said this development is neither a surprise nor a big deal.

"All this means is that mutual funds won't be able to buy into the new offering, and they were unlikely to be big buyers in the first place," said Jon Schotz, managing partner at Los Angeles-based alternative investment firm Kayne Anderson Capital Advisors' Kayne Saybrook Municipal Opportunity Funds.

Many mutual funds are not allowed to purchase below-investment-grade credits. However, it is not common for mutual funds to require divestments of existing holdings that lose their investment grade ratings, so this shouldn't trigger a major sell-off, although some funds may want to reduce their Puerto Rico holdings in order to respond to investor concerns about Puerto Rico's credit risk, sources said.

However, S&P did raise the stakes for the commonwealth's planned debt financing deal.

S&P analyst David Hitchcock said in a Feb. 4 webcast that a successful debt raise was factored into the downgrade of the GO debt to BB+ on watch with negative implications from BBB-, adding that a failure to raise at least $1 billion by the end of February could result in a further downgrade.

The commonwealth, which together with its major public agencies has over $71 billion in debt, said last month that it would launch a debt offering in late January or in February, and the timing has some muni investors scratching their heads.

"I'm not sure why they're not bringing something to market today, yesterday, or last week," Daniel Solender, lead portfolio manager for municipal bonds at investment manager Lord Abbett, said.

Solender doesn't expect the downgrade to have much impact on Puerto Rico's market access, as he explained, "The market has been betraying [Puerto Rico's debt] as a much lower-rated credit for a long time."

S&P cited concerns about Puerto Rico's liquidity and market access as the catalyst for the downgrade. The commonwealth maintains that it has enough liquidity to fund its operations through the end of the current fiscal year, June 30.

S&P's downgrade didn't affect Puerto Rico's sales tax bond-issuing authority, Cofina, which is widely considered to be one potential candidate for the new bond offering.

Still, sources agreed that the agency's intact rating doesn't stack the deck overwhelmingly in favor of using Cofina to issue new bonds.

Alan Schankel, managing director of municipal bond strategy at Janney Capital Markets, noted that, since a new Cofina issuance would be third-lien debt, it would have a lower credit rating profile than the existing Cofina bonds.

"Any [new] deal would have to be targeted at high yield or crossover-type investors," Lord Abbett's Solender said.

Solender said that he is relieved that the suspense about the effect of a downgrade is over.

"It's beneficial that [a ratings agency] actually made a move," Solender said. "It's good to see that the market hasn't had too adverse a reaction."

Trading in Puerto Rico's bonds has not been active since the downgrade, sources said.

Janney's Schankel noted that the sales tax bonds and general obligation bonds are still trading within a range consistent with 2014 prices.

S&P warned that its downgrade could trigger up to $940 million of debt acceleration and collateral-posting costs, although the agency said Puerto Rico is currently negotiating with certain debt holders to secure waivers on the acceleration provisions.

"Often, those [debt acceleration] rights have been waived in other situations," Schankel said.

The ratings agency also downgraded Puerto Rico's appropriation secured debt; its Employee Retirement System debt; and its Government Development Bank debt to BB on Feb. 4.

Distressed investors may not take this downgrade as the cue to buy more Puerto Rico securities.

David Tawil, co-founder and portfolio manager at distressed hedge fund Maglan Capital, already holds some Puerto Rico debt, and he's bullish on the credit in the long term, but he doesn't think this is the time to buy more.

"I think there will be more negative headlines coming," he said, explaining that he plans to buy more of Puerto Rico's debt in the future - just not yet.

Sources expect downgrades from Moody's Investors Service and Fitch Ratings to follow S&P's move.

Moody's public finance spokesman David Jacobson responded by e-mail Wednesday saying, "We placed the commonwealth's bonds on review for potential downgrade on December 11 and this will be resolved in the next few weeks."

Janney's Schankel noted that Moody's differs from S&P in its outlook on Cofina. While S&P didn't put the Cofina bonds on a negative watch, Moody's did, suggesting that those bonds could possibly be included in a Moody's downgrade.

Fitch Ratings wouldn't comment beyond its last rating action, which said the agency expects to resolve the negative watch by the end of Puerto Rico's current fiscal year.

Puerto Rico's treasury secretary Melba Acosta Febo and the federal bond issuing agency, the Government Development Bank, responded to the S&P downgrade in a Feb. 4 statement, saying, "While we are disappointed with Standard & Poor's decision, we remain committed to the implementation of our fiscal and economic development plans."

The statement added, "We are confident that we have the liquidity on hand to satisfy all liquidity needs until the end of the fiscal year, including any cash needs resulting from today's decision. In addition, the GDB and the Commonwealth of Puerto Rico have been in discussions with parties that have expressed an interest in arranging additional liquidity for the Commonwealth, and the Commonwealth continues to explore such options, including obtaining additional funding, as necessary."

Puerto Rico's federal finance authorities will hold a joint webcast to discuss the downgrade, the economic outlook, and the commonwealth's financing plans on Feb. 12.

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