Puerto Rico’s turbulent ride

Michael Taylor, Senior Municipal Analyst | September 26, 2013

  • Puerto Rico’s economic contraction and fiscal decline is persistent, well-documented and widely acknowledged within the municipal marketplace.
  • For Puerto Rico, continued access to affordable capital remains imperative for the maintenance of fiscal operations, liquidity, and maintaining investment-grade agency credit ratings.
  • We maintain the opinion that investing in Puerto Rico municipal bonds remains appropriate only for investors who can tolerate rating and price volatility.

Since publishing our June 2013 commentary on Puerto Rico’s weakening financial health, the market for the Commonwealth’s municipal bonds has been nothing but turbulent. Over the past several weeks, particularly following an August 2013 Barron’s cover story highlighting Puerto Rico’s persistently struggling economy and detailing widespread mutual fund exposure to Puerto Rico bonds, spreads widened considerably, with yields on longer-dated triple-tax-exempt Puerto Rico General Obligation (GO) debt trading in excess of 10% (from 7%) at times. Exacerbated by industry-wide mutual fund outflows, and perhaps some forced-selling, 2013 has proven to be the worst year for Puerto Rico bonds in over a decade. According to Standard & Poor’s Puerto Rico Index (Ticker: SAPIPR), Puerto Rico related bonds declined 16.97% over the 12-month period ending September 19, 2013.

The increased mainstream media interest in Puerto Rico has arguably perpetuated more trading among municipal market participants as recent volatility is not attributable to any given credit event (see Table I). Articles highlighting the island’s continued economic contraction and elevated unemployment, changes in gubernatorial and Government Development Bank (GDB) administration, the torrent of rating agency downgrades earlier this year, and questions as to the territory’s uncertain market access have all made headlines in recent months, contributing to bond underperformance.

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Credit fundamentals remain challenged

Puerto Rico’s economic contraction and fiscal decline is persistent, well-documented and widely acknowledged within the municipal marketplace. Over the past decade the government has routinely employed non-recurring budgetary measures, including the utilization of one-time bond proceeds to fund Commonwealth operations, both unusual for state-equivalent obligors and a clear sign of underlying credit weakness. The Commonwealth’s long-delayed fiscal 2012 audited financial statements, released on September 16, reveal a modest improvement in deficit spending, though for fiscal year 2014 a sizable budgetary deficit remains. Faced with limited options, the administration plans to rely on deficit borrowing, bank lines of credit and other one-time measures to close the budgetary gap. A return to structural budgetary balance, where recurring governmental revenues equal recurring expenses, appears unlikely.

Notwithstanding its lackluster effort in closing the current-year budget deficit, the new administration has taken some positive steps, including adopting comprehensive pension reforms designed to reduce cash flow pressures from growing pension obligations. In June, Puerto Rico’s Supreme Court upheld the constitutionality of the public pension reform bill passed by lawmakers, which freezes current defined benefit plans and moves all participants to a new hybrid defined contribution plan. Further, the reform raises the retirement eligibility age, reduces employee benefits (perhaps a first for a U.S. state/territory) and increases employee contributions (to >10%) — thus reducing the Commonwealth’s annual required payment. While the true impact will not be quantifiable until a new actuarial study is received, the Commonwealth’s total estimated annual pension cost of $800 million (10% of general fund revenue) for fiscal 2014 remains a drag on overall credit quality.

Market access remains critical

Although the underlying credit picture may not have changed materially in recent months, concerns remain regarding the island’s underlying credit quality and future access to affordable capital — a key source of liquidity for the fiscally-challenged U.S. territory. Unfortunately for Puerto Rico, continued market access remains imperative for the maintenance of fiscal operations, liquidity, and maintaining investment-grade agency credit ratings. Given the level of interdependence among roughly 20 on-island municipal bond issuers and demonstrated dependence on the marketplace for much-needed operating capital, fears over credit rating downgrades are warranted — with the Commonwealth itself on the brink of delving into speculative-grade territory (Baa3/BBB-/BBB-).

Puerto Rico Electric Power Authority’s $673 million August revenue bond issuance, marketed following Detroit’s bankruptcy filing, priced with its longest dated bonds yielding 7.12%. With yields rising across the island in recent weeks to distressed levels, the GDB has reduced previously-announced financing plans for the rest of 2013 to no more than $1.2 billion of new issues for all Commonwealth agencies.

Puerto Rico’s turbulent ride

Ultimately, for the Commonwealth of Puerto Rico, market access is integral to fiscal solvency. Given the persistent structural budgetary imbalance, any interruption in affordable market access could be seen as a tipping point towards severe credit/liquidity deterioration. A potential agency downgrade (to non-investment-grade) could potentially drive selling, or at the very least limit buyers’ participation in future deals — including the deals slated for this fall.

Attractive relative value opportunity

While acknowledging the aforementioned credit challenges, given the portfolio diversification and triple-tax-free benefits gained by holding certain Puerto Rico debt obligations, we believe that the opportunity costs of completely avoiding Puerto Rico debt may be substantial — especially since we believe some of the non-GO debt includes features that demonstrate investment-grade characteristics. When analyzing exposure to Puerto Rico, it is important to distinguish between credits that are supported by the commonwealth’s general obligation or appropriation pledge and those secured by revenues independent of the Commonwealth’s general revenues.

On balance, we believe that bonds supported by dedicated revenue streams and certain utility enterprise revenues are better-positioned to hold their value if Puerto Rico’s general obligation bonds were to fall below investment grade. Further, Puerto Rico holdings in the form of pre-refunded bonds, whose principal is held in an escrow account and generally invested in U.S. Treasury or Agency securities, should not be considered connected, in any way, to the underlying credit conditions in Puerto Rico.

We are acutely aware of the many challenges Puerto Rico and its issuers face and, as such, we are constantly monitoring our exposure to these credits and the risks inherent therein. We maintain the opinion that investing in Puerto Rico municipal bonds remains appropriate only for investors who can tolerate rating and price volatility.

Columbia Management exposure to Puerto Rico:  Please refer to Table II in this document to view Columbia Management mutual fund exposure to Puerto Rico issuers.

Standard and Poor’s rates the creditworthiness of corporate bonds, with 15 categories ranging from AAA (highest) to D (lowest). Ratings from A to CCC may be modified by the addition of a plus (+) or a minus (-) sign to show relative standing within the major rating categories.

Income from tax-exempt municipal bonds or municipal bond 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 income tax rules will apply to any capital gains.

There are risks associated with an investment in bond investments, including the impact of interest rates, credit, and inflation. In general, bond prices rise when interest rates fall and vice versa. This effect is usually more pronounced for longer-term securities.

Michael Taylor

Senior Municipal Analyst
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