Puerto Rico’s debt-restructuring process is likely to take longer and result in lower recovery values than originally expected as a result of Hurricane Maria.
However, we don’t think that Puerto Rico’s problems will carry over to the rest of the muni market.
All Puerto Rico bonds are speculative investments, in our view, and we don’t recommend them for muni investors looking for stable tax-advantaged income.
Puerto Rico’s financial problems existed long before Hurricane Maria made landfall. Before the terrible humanitarian disaster wrought by the storm, the commonwealth was already struggling with an unsustainable debt load.
The island started a bankruptcy-like process back in May 2017 in the hope of resolving some its financial problems, but the hurricane has only complicated the process. If anything, we think the disaster in Puerto Rico has pushed any resolution of its debt negotiations further into the future, and will likely lead to lower recovery values than many market investors in the island’s debt might once have expected.
And that’s not all. Over the longer term, Puerto Rico’s economy is likely to suffer as more people leave the commonwealth in the wake of the storm. The economic costs of a shrinking population will only complicate the island’s efforts to get its finances in shape.
Despite all that, we don’t believe Puerto Rico’s problems pose a risk to the broad municipal bond market. Although Puerto Rico ranks 10th among the states and U.S. territories in terms of outstanding municipal debt, it represents just 3% of the total muni market.1 We continue to view Puerto Rico bonds as speculative investments and do not recommend them to muni investors looking for relatively conservative tax-advantaged income.
How we got here
The Commonwealth of Puerto Rico has been struggling with a government debt crisis and poor demographic trends for years. Although Puerto Rico is a territory of the United States, it and its public corporations aren’t covered by U.S. Bankruptcy Code. To address this situation, Congress passed legislation, known as PROMESA, in 2016 that allowed the commonwealth’s government and its public corporations to enter into bankruptcy-like protection if they proved unable to service their debts. The legislation also established an oversight board to oversee Puerto Rico’s restructuring process.
The island’s government filed a petition to enter protection on May 3, 2017. The initial filing was for the commonwealth’s $13 billion of constitutionally protected general obligation (GO) debt, but additional Puerto Rican entities have since filed for protection as well. Puerto Rico has many different types of debt. Each is backed by different legal claims to Puerto Rico’s resources. The process laid out by the PROMESA law allows a single judge to oversee all the cases filed against various Puerto Rico issuers, rather than treating them as separate cases.
The table below shows the different issuers. All but a few are currently in default.
All Puerto Rico bonds are speculative investments, in our view
|Debt type||Moody’s/S&P rating||In default?||Outstanding amount (billions)|
|General Obligation and Guaranteed||Ca/D||Yes||$18.06|
|Sales Tax Financing Corporation (Subordinate) (COFINA)||Ca/D||Yes||$9.72|
|Puerto Rico Electric Power Authority||Ca/D||Yes||$8.96|
|Sales Tax Financing Corporation (Senior) (COFINA)||Ca/D||Yes||$7.58|
|Government Development Bank for Puerto Rico||C/NR||Yes||$4.13|
|Puerto Rico Aqueduct & Sewer Authority (PRASA) Senior Debt||Ca/CC||No||$3.89|
|Highways and Transportation Authority 1998 Resolution||C/D||Yes||$3.50|
|Employees Retirement System||C/CC||No||$3.16|
|Infrastructure Financing Authority (Rum Tax)||C/D||Yes||$1.78|
|Public Finance Corporation (Lease Debt)||C/D||Yes||$1.20|
Sources: Standard &Poor’s and Moody’s for credit ratings, as of 10/16/17, Bloomberg for default status, as of 10/16/17, and Moody’s for “outstanding amount,” as of 5/4/17.
The damage from Hurricane Maria further complicates the recovery process
Puerto Rico’s financial resources to repay bondholders were already strained prior to the hurricanes, and the storms only worsened matters by destroying infrastructure and businesses. Nearly a month after Hurricane Maria made landfall, 91% of the commonwealth is still without power, roughly half the commonwealth does not have telecommunication services, and approximately one-third of the commonwealth is without its regular water supply.2
Since Hurricane Maria, all work and most resources have gone toward supporting the recovery, and negotiations between Puerto Rico and bondholders have been on hold. Moody’s downgraded eight different Puerto Rican issuers further into junk territory all with negative outlooks as a result of the storm. The commonwealth’s GO bonds were downgraded to Ca from Caa3, and its senior-most tax-backed debt (COFINA) was also downgraded to Ca from Caa3. The agency said the “negative outlook is consistent with ongoing economic pressures…potentially driving bondholder recovery rates lower…”
Over the longer-term, we think outmigration from the islands will increase, putting additional pressure on future revenues for bondholder recoveries. An alternative view is that rebuilding efforts could spur economic activity. However, our view is that outmigration and continued economic troubles are the more likely scenario due to the severity of the storm.
The president can’t “wipe out” Puerto Rico’s debt, in our view
Puerto Rico’s story experienced another wrinkle recently, when President Donald Trump said the commonwealth’s debt will have to be wiped out. Rather than helping, that commented created doubt about the restructuring.
After the president’s comments, the price of the most actively traded Puerto Rico GO bond fell from roughly 44 cents on the dollar to 32.5, according to Bloomberg. White House officials have since said the president’s comments shouldn’t be taken literally and that the administration wants the debt restructuring to be handled through the courts via the already created oversight committee and congressionally approved bankruptcy-like process. The president’s unilateral authority the alter Puerto Rico’s financial situation is likely limited, in our view, although he can attempt to influence debt negotiations via either disaster relief funding or public statements.
Puerto Rico bond price movements
Source: Bloomberg, as of 10/13/17.
Note: Selected securities were chosen because they were the most actively traded uninsured bond for each entity over the three- months ending 10/13/17. Committee on Uniform Security Identification Procedures (CUSIP) numbers for the securities shown are 74529JHN8 (COFINA), 74514LE86 (GOs), 745160RC7 (PRASA), and 74526QVX7 (PREPA). For illustration only.
Insured Puerto Rico bonds should still be treated with caution
What about Puerto Rico bonds that carry insurance? Insurance can add a layer of protection for bondholders, as the insurers of a particular muni bond pledge to make timely interest and principal payments in the event of a default or restructuring.
However, we would still treat insured Puerto Rico bonds as speculative investments. We believe the underlying credit characteristics of the issuer should fit your risk tolerance before taking insurance into consideration. And it’s important to remember that insurance pledges are only as reliable as the financial strength of the insurance company.
Bond insurers agree to make timely interest and principal payments on the bonds they insure
Source: Schwab Center for Financial Research, for illustration only. Payments by the insurance company are subject to their claims paying ability.
Assured Guaranty (Assured), National Public Finance Guaranty Corporation (National), and Ambac insure the largest amount of Puerto Rico bonds. Any insurer’s ability to pay on the bonds it insures will depend on its financial health, which Puerto Rico bonds it insures and the magnitude and timing of any losses.
According to CreditSights, a research firm, Assured and National’s ability to pay on the Puerto Rico bonds they insure is “strong,” but CreditSights has “mounting concerns about National’s claim paying resources.” The firm tested a scenario under which it assumed a 60% loss to all Puerto Rico bondholders as a result of the restructuring. According to CreditSights, this would erode nearly 70% of National’s claims-paying resources.
Things look a little different for Ambac, which has a large exposure to Puerto Rico’s tax-backed (COFINA) bonds. The impact on Ambac’s claims-paying resources will depend on the magnitude of the loss that COFINA bondholders take through the restructuring process.
The insurance companies’ ability to pay depends on their claims-paying resources
|Exposure (value in millions)||
|GO & guaranteed||$2,629||$1,179||$277|
|Sales tax backed (COFINA)||$619||$4,170||$7,321|
|Electric authority (PREPA)||$1,109||$1,789||$0|
|Claims paying resources||$11,226*||$4,607||$8,813|
|Claims paying resources as a percent of total Puerto Rico exposure||137%||55%||92%|
Source: CreditSights, as of 10/4/17.
*Note: total of all entities for Assured.
Puerto Rico bonds insured by Assured and National still carry investment-grade ratings and are generally pricing near par because the insurers have been making payments since Puerto Rico defaulted. Bonds insured by Ambac are also generally trading near par because of the insurer’s backing. One other insurer hasn’t been keeping up with its payment obligations: Financial Guaranty Insurance Company has been covering only a quarter of the value of the payments that have come due.
One way to think of this arrangement is that investors with insured Puerto Rico bonds are effectively holding tax-exempt corporate debt, because they are relying on the insurers to make interest and principal payments on Puerto Rico’s behalf. They keep the tax advantages that come with investing in municipal bonds, but the payments are now dependent on the insurers’ ability to pay, not the issuer’s.
For the insured bonds to continue to price near par, the insurers will have to continue payments and maintain their own investment grade credit ratings. And they will have to continue to do so even after Puerto Rico’s debt is restructured, which could add to the insurers’ financial burden, particularly if they have to make up the difference of any losses to bondholders.
We suggest caution for most investors. (For more information on insurance companies, please see 6 Things Investors Should Know About Municipal Bond Insurance.)
We don’t think Puerto Rico’s problems will affect the rest of the municipal bond market
Conditions in most of the muni market are stable, in our view, and we don’t believe the situation in Puerto Rico will significantly affect the performance of a diversified portfolio of muni bonds.
The direction of Treasury rates and Federal Reserve policy continue to be the major driving factors of municipal bond performance. Puerto Rico’s problems have been under discussion and in the press for years, giving markets time to prepare for the restructuring. The bankruptcy process approved by Congress for Puerto Rico is also specifically limited to Puerto Rico and cannot be used by other states, all of which have far less debt per capita, currently, than the commonwealth.
What to do now
If you own Puerto Rico bonds that are in default and your goal is to generate income, understand that you own noninterest-bearing investments that may not pay again for some time, potentially years. If you are attempting to speculate on the possibility that the recovery amounts that could be paid in the future for Puerto Rico bonds will be higher than what the market currently expects, be warned that the market is generally an effective pricing mechanism, in our view, and has already priced in the damage caused by the hurricane. Future bond prices and expectations for recovery rates may change, however.
1Source: Bloomberg, as of 10/13/17.
2Source: Status.PR, as of 10/13/17.