Puerto Rico’s weakening fiscal and economic condition presents serious concerns for municipal bond investors.
Investors are attracted by the portfolio diversification and triple-tax-free benefits of certain Puerto Rico debt obligations, but the credit challenges are significant.
We believe that rigorous research is essential to identify those opportunities that feature investment-grade characteristics.
In December 2012, we expressed concern about Puerto Rico’s fiscal health given its sizable and persistent structural budgetary imbalance, low pension funding ratios, increasing debt burden, weak economic conditions and uncertainty related to the newly elected governor’s economic and fiscal policies. Since December, Puerto Rico’s fiscal condition has weakened further and the new administration’s approach to addressing the mounting fiscal challenges raises new concerns. Failure to make meaningful progress in closing the large structural budget deficit due, in part, to persistent economic weakness could result in further rating downgrades and diminished market access.
Recent budget forecasts estimate the budget deficit for the fiscal year ending June 30, 2013 will be more than double the deficit originally projected. Faced with limited options, the administration plans to rely on deficit borrowing, bank lines of credit and other one-time measures to close the budget gap.
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. Temporary corporate excise tax amendments and extensions are projected to increase revenues by $360 million (4.6% of revenues) during 2014.
However, these positive fiscal measures are more than offset by the proposed 2014 budget which includes an 8.3% increase in spending, increased deficit borrowing and an overly-optimistic 16% growth in revenues. Revenue growth, largely from proposed, but not yet approved, sales tax increases, has the potential to underperform projections given the poor historical collection rate on the Island. In addition, there is risk that higher taxes may further slow an already ailing economy.
Despite 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-General Obligation (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. There may in fact come a time when Puerto Rico bonds become an attractive buying opportunity – at prices that appropriately reflect the risks.
There are risks associated with fixed income investments, including credit risk, interest rate risk, and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is more pronounced for longer-term securities.