Puerto Rico’s credit challenges intensify

Columbia Management Municipal Investment Team, | July 23, 2014

  • Puerto Rico’s new debt restructuring law led to a Moody’s downgrade.
  • Our assessment of the relative strength of Puerto Rico’s general obligation bonds remains unchanged, as they are not covered by the new law.
  • While we believe that the constitutionality of the new law will be heavily contested, the implications of a voluntary default to revenue bond creditors would be material.

In late June, Puerto Rico signed a law that makes it easier for some public corporations to restructure debt obligations. With over $70 billion in outstanding debt, the stakes are high for Puerto Rico and bondholders. On July 2, largely as a result of this new law, Moody’s downgraded further into junk territory Puerto Rico general obligation and other debt. This three-notch downgrade comes only six months after Puerto Rico was reduced to junk rating status. The passage of the law — Puerto Rico Public Corporation Debt Enforcement and Recovery Act (“Act”) — undermines a long-held belief that the U.S. Territory will take any and all necessary actions to preserve its creditworthiness. At its core, the law is essentially a bankruptcy bill and we expect that the constitutionality of many of its provisions will be heavily litigated.

While acknowledging the interrelation of on-island credit names, our assessment of the relative strength of Puerto Rico’s general obligation and sale tax (COFINA) obligations remains unchanged as a result of this legislation, since these credits are explicitly ineligible to seek relief under the Act. However, the move to restructure public corporation debt indicates a previously unseen willingness to not fulfill certain debt obligations, especially if further economic weakness creates additional strain on the Commonwealth.

While we believe that the constitutionality of the new law will be heavily contested, the implications of a voluntary default to revenue bond creditors would be material. Puerto Rico’s credit deterioration has negatively impacted values of the island’s bonds. At Columbia Management, we have acknowledged Puerto Rico’s credit challenges for a very long time — largely due to our belief that there is no easy way for the government to spark economic growth and enact meaningful fiscal reform. We continue to maintain limited to no exposure to Puerto Rico in most of the accounts we manage, with no exposure in any of our short or intermediate maturity muni funds. We are constantly monitoring our exposure to these credits and maintain the opinion that investing in PR municipal bonds remains appropriate only for investors who can tolerate rating and price volatility.

Disclosure

There are risks associated with an investment in a municipal bond fund, including credit risk, interest rate risk, prepayment and extension risk, and geographic concentration risk. See the Fund’s prospectus for information on these and other risks associated with the Fund. In general, bond prices rise when interest rates fall and vice versa. This effect is more pronounced for longer-term securities. 

Income from tax-exempt funds may be subject to state and local taxes and a portion of income may be subject to the federal and/or state alternative minimum tax for certain investors. Federal and state income tax rules will apply to any capital gain distributions and any gains or losses on sales.

The Moody’s bond rating scale goes from Aaa (highest) to C (lowest). If a rating is upgraded three notches by Moody’s for example, it goes from Baa to Aaa or Baa to C or lower in a downgrade. 

Columbia Management Municipal Investment Team

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