Among the small group of closed-end funds with higher exposures to Puerto Rico (roughly in the range of 2.5% up to 6%), Fitch believes that even a full writedown of Puerto Rico holdings would not trigger any rating downgrades of preferred stock issued by these funds. Most of the debt already trades at distressed prices, muting the impact of any further price declines.
In the past, Puerto Rico bonds were among the most popular holdings for municipal investors due to the commonwealth's triple tax free status, a factor contributing to the historically high demand for these bonds.
Among the areas of focus when Fitch rates the preferred stock of US muni closed-end funds are a measure of the funds' relative proximity to mandatory deleveraging provisions and the strength of mandatory deleveraging provisions compared to rating criteria. Stress scenarios used in our analysis depress the current market value of the portfolio to reflect our views of future volatility and liquidity of each asset class to ensure that principal and interest of a fund's outstanding leverage can be paid to investors. Secondly, we assess the cushion between the current stressed market value and the level that would require a mandatory deleveraging.
Under a significant market event such as Puerto Rico, market declines impact both the market value of the portfolio (as the bonds trade down) and the stressed market value given a presumption of increased volatility (given that Puerto Rico's bonds have been downgraded to 'CC'). These factors together can cause asset coverage to decline considerably and tend to lead managers to reduce leverage. Such deleveraging was seen in 2013 during the general decline in muni bond values after the market's reaction to the "taper tantrum" when the Fed signaled rising rates, and again more recently as Puerto Rico's fiscal crisis became more apparent.
Due to the protracted issues that have led to Puerto Rico's current situation, hedge funds and distressed debt investors have expanded their holdings of Puerto Rico, replacing many of the traditional retail holders with closed-end and open-end mutual funds.
Given reduced exposure, further declines in Puerto Rico's bonds are not anticipated to drive managers of closed-end funds to deleverage further. Furthermore, closed-end funds, unlike their open-end counterparts, are by design not subject to the risk of investor redemptions - an additional protection that we believe mitigates any pressure on managers to liquidate holdings, even as Puerto Rico's condition is expected to worsen before improving.
Additional information is available on www.fitchratings.com.
The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article can be accessed at www.fitchratings.com. All opinions expressed are those of Fitch Ratings.
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