Puerto Rican debt holdings in limbo

All bets are off when it comes to the likelihood of distressed debt-focused hedge funds and municipal bond fund managers making money or at least coming out whole on their investments in the debt of the Commonwealth of Puerto Rico.

Gov. Alejandro Garcia Padilla said in late June that Puerto Rico can't repay the $72 billion in debt that it has incurred through issuance of general obligation bonds, sales tax-backed bonds and public corporation/agency bonds.

Most U.S. defined benefit and defined contribution plans, endowments and foundations won't be directly affected by the outcome of Puerto Rico's debt restructuring because, as tax-exempt entities, they largely don't invest in tax-exempt debt.

However, a slice of their money managers, especially high-yield debt managers and distressed debt hedge funds, have exposure to the island's financial crisis through their bond holdings.

The breakdown of debt holders is about one-third hedge funds, one-third mutual funds and one-third individual retail investors, said Matt Fabian, a partner at specialty researcher Municipal Market Analytics Inc., Westport, Conn.

“It is extremely difficult to project the returns investors might expect from the many ways that Puerto Rico may restructure its entire capital structure,” Mr. Fabian said.

“There are too many moving parts. What is clear is that the capital structure will need much deeper haircuts than have been proposed so far,” Mr. Fabian stressed.

The U.S. territory has three options for dealing with its debt, observers said.

The first and most viable option is debt restructuring. The second option is convincing the U.S. Congress to pass legislation that will extend Chapter 9 municipal bankruptcy protection to the U.S. territory.

Cesar Miranda, Puerto Rico's secretary of the Department of Justice, already has acted on the third option by announcing that the commonwealth will appeal to the U.S. Supreme Court to overturn decisions by two lower courts.

The 1st U.S. Circuit Court of Appeals in Boston on July 6 affirmed the February decision of the U.S. District Court in San Juan, Puerto Rico, to strike down the 2014 Puerto Rico Public Corporation Debt Enforcement and Recovery Act. That law gave municipalities, including public utilities and other government agencies, on the island bankruptcy protection to enable them to restructure. U.S. Chapter 9 bankruptcy law specifically excludes Puerto Rico.

Mr. Padilla signaled his government's willingness to “make difficult decisions to meet the challenges we ... know are ahead,” in a June 29 statement.

Citigroup Inc., which was hired by the commonwealth as a broker-dealer for the restructuring process, is hosting a high-profile meeting at its New York headquarters on July 13 for Puerto Rican officials, their advisers and institutional creditors, said a source who spoke on condition of anonymity. Interest in the negotiations is so high that Citigroup will provide live-stream coverage of the meeting, the source said.

Edward “Ted” Hampton, senior vice president and a Puerto Rico debt analyst at Moody's Investors Service Inc., New York, said, “We expect a contentious, litigious, drawn-out process as Puerto Rico deals with its debt situation.”

Among the hedge fund companies known to hold Puerto Rican debt: Angelo Gordon & Co., BlueMountain Capital Management LLC, Brigade Capital Management LP, Centerbridge Partners LP, Davidson Kempner Capital Management LP, Fir Tree Inc., Knighthead Capital Management LLC, Marathon Asset Management LP, Monarch Alternative Capital LP, Stone Lion Capital Partners LP and D.E. Shaw Group, according to documents from the appeals court case and Bloomberg reports.

Traditional money managers that own Puerto Rican municipal bonds include Franklin Advisers Inc., Fundamental Advisors LP, Goldman Sachs Asset Management, Goldman Sachs Group and OppenheimerFunds, according to court documents from the appeal.

Some of the hedge funds, traditional money managers and insurance companies already have banded together into two ad hoc groups, depending on the specific kind of bonds they hold, in order to effect the best possible restructuring terms, sources confirmed.

The Puerto Rico Electric Power Authority Bondholder Group, for example, said in a July 1 statement that “over the past several months of direct negotiations with PREPA — the territory's public utility — and the Government Development Bank, we have made progress toward a workable solution for PREPA and are hopeful that we have established a foundation for reaching an equitable deal for all PREPA stakeholders.”

The PREPA group, for example, agreed to allow the utility to skip a July 1 debt payment and extended its forbearance agreement to Sept. 15, a statement from the group said.

One municipal bond analyst who asked not to be named said “the PREPA deal likely is more than half-baked at this point. The deal is coming together.”

Less is known about the activities of the second ad hoc group of investors that own the debt of other Puerto Rican public corporations, and general obligation and sales tax bonds. But sources said the hedge fund managers that dominate this team have more investment flexibility, patience and expertise to navigate the restructuring process.

For example, Bruce Richards, CEO and co-managing partner, of credit hedge fund manager Marathon Asset Management, acknowledged in an e-mail that while “Puerto Rico faces challenges with its fiscal deficits, excessive debt burden and weak economic growth,” his company is taking advantage of the situation to find investment bargains.

“Marathon has performed comprehensive due diligence on Puerto Rico's municipal debt and selectively taken large positions at heavily discounted prices with an outlook and willingness to opportunistically deploy additional capital,” Mr. Richards said.

New York-based Marathon manages a total of $12.5 billion in distressed debt hedge funds. Mr. Richards declined to give the amount of Puerto Rican bonds held.

Hedge fund managers “often have different time frames and objectives than traditional retail bondholders,” said Alan Schankel, managing director, Janney Capital Markets, Philadelphia, in a report about the Puerto Rican debt market.

Hedge funds moved into the market in late 2013 to snap up bonds at discounted prices and “whereas the retail investor may be willing to "clip the coupon' while waiting (and hoping) for the bond to be redeemed at par upon maturity, a hedge fund may be very satisfied with a sale (or recovery after restructuring) at 65 cents if the purchase price was 53 (cents),” he said.

With regard to Puerto Rico's attempts to alleviate its financial woes beyond debt restructuring, sources predicted that because the two lower courts were in agreement, the U.S. Supreme Court is unlikely to take up Mr. Miranda's appeal, should he file it, to allow the territory's municipalities and public corporations to seek Chapter 9 bankruptcy protection.

Additionally, even if a bill pending in Congress to extend Chapter 9 bankruptcy protections to Puerto Rico — H.R. 870, the Puerto Rico Chapter 9 Uniformity Act of 2015, introduced by Puerto Rico's non-voting member of Congress, Pedro Pierluisi — were to be passed and enacted, sources said its impact would be limited.

That's because the majority of the commonwealth's debt load is from general obligation and sales tax bonds issued by the territory's government and protected by Puerto Rico's constitution. The bill proposes treating Puerto Rico like a state under Chapter 9, and states are not entitled to file for bankruptcy protection. Only the debt of municipalities would be protected.

Among the Puerto Rican public corporations and agencies that would be eligible for Chapter 9 protection, should the bill be enacted, are PREPA, the Convention Center District Authority, the Highways and Transportation Authority and the National Parks Co.

“While I think it might make sense to let Puerto Rico have the same access to bankruptcy relief as ... municipalities do, it won't be a panacea,” Mr. Hampton said.

“It's highly unlikely that Puerto Rico will be able to restructure its debt beyond those bonds of the public corporations,” Mr. Hampton added, noting that “even if Congress does approve Chapter 9 for Puerto Rico, it probably will be a long time before the commonwealth will be able to exit from bankruptcy for those bond issuers that are eligible.”

Money managers are carefully watching the progress of the bill.

BlueMountain Capital Management, Knighthead Capital Management, Angelo Gordon, Marathon Asset Management, Franklin Advisers, and D.E. Shaw Galvanic Portfolios, all of which hold PREPA bonds, have hired Venable LLP to oppose the bill, according to lobbyist registration documents and interviews with sources.

BlueMountain also has hired Gibson, Dunn & Crutcher LLP. n

Bloomberg contributed to this story.