Hedge funds are known as heavy buyers of Puerto Rico bonds, but as the U.S. commonwealth works to restructure about $72 billion in debt, it is a pair of mutual-fund firms that may take the lead in negotiations.
OppenheimerFunds Inc. and Franklin Advisers Inc. together owned about $10.8 billion face amount of bonds, representing 15% of Puerto Rico’s debt as of March 31, according to The Wall Street Journal’s analysis of data from Morningstar Inc. Franklin has experience pushing aggressively to pare losses in restructurings and the two firms’ large stakes will give them added clout with Puerto Rico.
For more than a decade, Oppenheimer and Franklin packed Puerto Rico bonds into their municipal-bond funds because they pay high interest rates, wagering the commonwealth wouldn’t default. The bonds’ prices have fallen more than 30% since July 2013, amid building fears that declining tax revenues would sap the government’s ability to honor its debts.
Oppenheimer and Franklin have held on to most of their investments, in part because they own too many bonds to sell them all without depressing prices further. Franklin also is involved in a similar showdown with Ukraine over about $7 billion bonds it bought that the war-torn European country says it can no longer pay.
“We have been managing investments in Puerto Rico for more than 20 years, and remain steadfast in serving the long-term interests of our shareholders,” a spokeswoman for OppenheimerFunds said. A spokeswoman for Franklin declined to comment.
The firms’ outsize role in Puerto Rico reflects the massive growth of mutual funds since the financial crisis as individual investors hungry for yield piled in. Some firms have put this flood of money into large concentrated investments they can’t quickly exit if prices fall. Franklin’s assets under management have grown by 40% to $880 billion in March from $523 billion at the end of 2009.
Rochester, N.Y.-based Oppenheimer owned about $7.4 billion face amount of Puerto Rico bonds as of March 31, virtually unchanged from its exposure in June 2013. San Mateo, Calif.-based Franklin managed to cut its holdings by 35% to $3.4 billion from $5.2 billion over the same period.
Their largest investments are in bonds known by their Spanish acronym, Cofina, which are backed by tax revenues. The firms together owned $4.1 billion, or 27%, of outstanding Cofina bonds as of March, according to Morningstar data. The sum includes so-called zero-coupon bonds, which are difficult to value.
Hedge funds have dominated trading of Puerto Rico bonds since the jitters of summer 2013 led many individual investors and mutual funds to sell out. Firms with expertise trading distressed debt, like Brigade Capital Management, Perry Capital and Stone Lion Capital, were among the largest buyers of the bonds.
Low default rates in corporate debt have led such distressed-debt specialists to instead focus on cash-strapped governments like Greece, Argentina and Puerto Rico. But while prices of Greek and Argentine bonds bottomed out at less than 20 cents on the dollar at the height of their debt crises, much of Puerto Rico’s debt still trades between 50 and 70 cents, according to MSRB data. That means the hedge funds will need to recover more in a Puerto Rico restructuring than speculators in the Greek and Argentine defaults did to turn a profit.
Further complicating matters, Oppenheimer and Franklin paid much more for their bonds, which traded close to 100 cents on the dollar before 2013, than the hedge funds, meaning they will be less likely to accept a lower recovery than hedge funds might agree to.
“They’re going to play an enormous role,” said Robert Donahue, managing director at Municipal Market Analytics, a research firm in Concord, Mass. “To show any retreat now would be very surprising.”
Because Puerto Rico is neither a U.S. state nor a sovereign nation, the restructuring process is uncertain. All states are barred from filing for bankruptcy but state agencies and cities, such as Detroit, can seek protection under Chapter 9 of the U.S. Bankruptcy Code.Puerto Rico is lobbying the U.S. Congress for a law allowing some of its entities to file for bankruptcy protection. Until such a law passes, the island’s leaders must negotiate with creditors without the chapter 9 process.
“Things can get messy among creditors and different groups of creditors quickly,” said David Hammer, executive vice president and municipal bond portfolio manager at Pacific Investment Management Co.
Warning signs from the commonwealth have grown since Gov. Alejandro García Padilla called for talks with creditors last month. The Government Development Bank for Puerto Rico announced plans early this month to attempt to exchange its old bonds at deep discounts for cash or new bonds.
Hedge funds that own GDB bonds, led by Avenue Capital Group, Brigade Capital Management, Candlewood Investment Group, Fir Tree Partners and Perry, have formed a committee and hired law firm Davis Polk & Wardwell LLP, said people familiar with the matter. Puerto Rico is working with Cleary Gottlieb Steen & Hamilton LLP, which specializes in advising governments that default on bonds, and hired Citigroup to help structure debt exchanges.
The GDB is a relatively small piece in the complex puzzle of Puerto Rico’s debt crisis and it will be difficult to craft a debt swap for the bank without more clarity on how the government’s other bonds will be treated, lawyers and fund managers say.
Puerto Rico says its debt includes about $18.6 billion of general obligation bonds and government-guaranteed debt, $15.2 billion of Cofina bonds and $24.1 billion of bonds borrowed by government agencies, like the Puerto Rico Electric Power Authority, also called Prepa. Many investors hold bonds across the different buckets, each of which could recover different amounts in a restructuring.
And with a bankruptcy filing possible, many bondholders fear that if they swap into new bond at a discount now, they risk being restructured again in court, likely meaning further losses.
Brigade and Fir Tree, for example, own GDB and general obligation bonds, while Franklin and Oppenheimer hold Prepa bonds and a variety of other Puerto Rico debts.
Investors in different buckets are splitting into separate committees in anticipation of a legal fight. Hedge-fund holders of about $1 billion Cofina bonds have hired law firm Quinn Emanuel Urquhart & Sullivan to represent them, a person familiar with the group said. Investors with significant holdings in other buckets are being turned away from the committee to avoid conflicts of interest, he said.
—Matt Jarzemsky contributed to this article.
Write to Matt Wirz at matthieu.wirz@wsj.com and Aaron Kuriloff at AARON.KURILOFF@wsj.com
Corrections & Amplifications:
OppenheimerFunds Inc. and Franklin Advisors Inc. own $4.1 billion of “Cofina” tax-backed bonds. A chart accompanying an earlier version of this article incorrectly suggested the sum constituted all the firms’ holdings of Puerto Rico bonds. (July 20)
By MATT WIRZ and AARON KURILOFF
Mutual Funds Are Front and Center in Puerto Rico Talks
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