Puerto Rico, which is battling a financial crisis of high unemployment and a crushing debt load, is under pressure to show investors and credit-rating agencies that it can still borrow money from the capital markets.
A group of hedge funds and private equity firms may help it do just that, but at a high price.
Bankers at Morgan Stanley have been reaching out to about a dozen hedge funds, private equity firms and other large investors to gauge their interest in providing up to $2 billion in financing to Puerto Rico, according to people briefed on the discussions.
The talks are fluid, but one of these people, who spoke on the condition of anonymity, said the debt could carry yields as high as 10 percent, more than double what a highly rated city or state pays to borrow in the current municipal debt market.
The proposed financing shows just how dire Puerto Rico’s situation has become. “It’s unprecedented,†said Robert Donahue, managing director at Municipal Market Advisors. “It’s a reflection of the increasing realization that Puerto Rico has exceeded the risk appetite of the traditional municipal bond market.â€
A spokesman for the Government Development Bank for Puerto Rico, which oversees debt deals for the island, declined to comment. A Morgan Stanley spokeswoman also declined.
Investors have been driving down prices of the island’s bonds in recent months, fearing Puerto Rico could default on its outstanding debts. Hedge funds have already been buying Puerto Rico debt at steep discounts, but in relatively small amounts.
The proposed debt deal being cobbled together by Morgan Stanley would be among the largest wagers on Puerto Rico â€" if not the entire municipal debt market â€" by hedge funds and other so-called alternative investment firms. Hedge funds are big buyers of debt and stocks of troubled companies, but they are relative newcomers to municipal bonds.
Puerto Rico’s persistent financial problems have taken on a new urgency. Last month, Moody’s Investors Service said it was putting Puerto Rico’s credit rating on review for a downgrade. A one-notch downgrade by any of the ratings agencies could have painful consequences. About $1 billion of debt repayments would be accelerated and additional collateral would have to be posted for interest rate swaps, according to Moody’s, which now rates Puerto Rico Baa3, one notch above junk.
Officials in Puerto Rico have insisted that there is ample liquidity to last through the end of the government’s fiscal year, June 30, without additional borrowing. They say they have made progress on increasing tax revenue and cutting pension liabilities.
Still, Moody’s is prodding Puerto Rico to tap the debt market before the end of the month â€" which would show that it can do so under financial strain.
“An inability or unwillingness to access the market in January 2014 would be a negative rating factor†for Puerto Rico, Moody’s said in a research note just before Christmas.
The people briefed on the proposed financing said Morgan Stanley had not been hired by Puerto Rico to underwrite a deal. Rather, the bankers are acting on their own to put together a proposal to take to Puerto Rican officials.
The people said the bank’s strategy was to line up buyers before Puerto Rico sold the bonds. Analysts say that if any bond sale failed to attract enough investors, it would send a dangerous signal to the broader market.
Puerto Rican officials have discussed other possible bond deals, including selling debt backed by sales tax revenue. Such deals could come by the end of February.
Moody’s said the new debt could be used to help close an $820 million budget gap and repay various short-term debts that financed last year’s budget deficit.
While selling bonds in the municipal debt markets is a vital financing source for many states and cities, Puerto Rico has come to depend on debt to keep the government operating. For decades, the commonwealth has found near limitless demand for its bonds, which carry interest that is exempt from federal, city and state taxes, making them attractive investments for residents of the United States mainland.
The last Puerto Rican government entity to borrow in the municipal market was the island’s electrical authority, which sold $673 million in bonds last August at yields of about 7 percent. Since then, investors have grown more skittish about the prospect of a default by Puerto Rico, and their fears were heightened by Detroit’s bankruptcy filing.
As a United States territory, Puerto Rico cannot file for Chapter 9 federal bankruptcy protection. But some investors fear that the lack of a court-supervised bankruptcy process could lead to a free-for-all among Puerto Rico’s creditors or the need for a bailout from a reluctant federal government.
Such fears caused traditional holders of Puerto Rico bonds â€"mutual funds and wealthy individuals â€" to sell their bonds. That’s when hedge funds stepped in as buyers, betting that default concerns were overblown.
“I don’t think the commonwealth is near the precipice,†said David D. Tawil, co-founder of the hedge fund Maglan Capital, which owns some Puerto Rico debt. “They still have some arrows left in the quiver before they have to resort to restructuring.â€
Yields on Puerto Rico’s 30-year general obligation bonds are now at 8.6 percent, according to Thomson Reuters Municipal Market Data. By comparison, yields on a benchmark of highly rated municipal bonds are 3.9 percent.
Some investors may have been too early in betting on Puerto’s Rico recovery.
In a letter to investors on Tuesday, Third Point, the hedge fund run by Daniel S. Loeb, said Puerto Rico bonds were among his firm’s top five losing investments in the fourth quarter.
