Trouble in paradise: Q&A about Puerto Rico bonds

Chad Farrington, CFA, Head of Municipal Bond Research | January 2, 2014

Why has Puerto Rico become such an issue now?

Should investors be concerned with a downgrade or default?

Is Puerto Rico a systemic risk for the municipal market?

Historically, Puerto Rico (PR) bonds’ high yield and triple tax exemption (federal, state and local) had been a big lure for many institutional investors, such as mutual funds. PR debt exposure in municipal bond funds, namely single-state municipal bond funds, proved advantageous for shareholders — that is until Puerto Rico debt started trading more in line with its weak fundamental credit characteristics.

Since late summer 2013, municipal bonds issued by Puerto Rico have lost more than 20% of their value, with more downside risk possible. Cumulatively, municipal bond fund shareholders have a large stake in Puerto Rico debt, with more than 77% of municipal bond funds holding some type of PR debt.* Given the widespread exposure, we thought providing answers to some common investor questions may be helpful.

Q: Given the long-standing credit stress in Puerto Rico, why is this all coming to a head now?

A: It is hard to pinpoint exactly what set the current sell-off in motion. It is likely that the torrent of negative media attention toward PR bonds in the midst of an overall flight from fixed income, not to mention the high profile Detroit bankruptcy filing this summer, contributed to investors’ concerns about other weak municipal issuers.

Puerto Rico’s financial problems have been simmering for decades. The Commonwealth has an ailing economy, recurring budget deficits and severely underfunded pension systems. Unlike most other municipalities, PR issues debt to pay annual operating expenses. The chart on the following page provides a snapshot of Puerto Rico’s unrestricted net asset deficit — accrued over years and running annual operating deficits — and the percent of funding for the government employee pension system. The government employs approximately 25% of the island’s labor force, further stressing the pension plans. Over time, the asset deficit has gone up and the government’s funding of its main pension system has gone down.

PRBonds

Source: Puerto Rico Comprehensive Annual Financial Reports (CAFR), 2012. Unrestricted Deficit (Left hand scale) — accrued (cumulative) deficits. ERS Funded Ratio % (Right hand scale) — percent of Employee Retirement System accrued pension liability that has been funded.

While PR leadership has made recent progress in raising revenue and reforming pension plans, the weak economy and ongoing structural budget imbalance remain tremendous headwinds to ultimate stabilization.

Q: What happens if the credit rating falls below investment grade?

A: The market is already pricing most PR bonds below investment-grade levels. However, bond prices could fall even more as the buyer base narrows further. From a credit perspective, we see several looming possibilities:

  • A credit downgrade to below investment grade by S&P or Moody’s would increase the interest rate on some outstanding notes;
  • Some of Puerto Rico’s bond swap transactions would be terminated, creating a payment liability and eliminating a hedge against rising interest rates;
  • Rollover risk on floating-rate bonds would be escalated; and
  • Inability to access the bond market for capital spending or planned deficit financing.

Each of these possibilities applies even more pressure to PR’s already stressed liquidity levels.

Q: If Puerto Rico cannot access the bond market, how likely is a default?

A: We do not see default as a likely outcome in 2014, given current liquidity levels and the support of the Government Development Bank, a government-owned corporation of Puerto Rico that serves as the Commonwealth’s government bond issuer, intra-governmental bank, fiscal agent and financial advisor. Beyond 2014, however, Puerto Rico needs economic growth to generate additional revenue to meet future obligations. Unfortunately, reducing workforce, cutting other spending and increasing taxes tend to run counter to generating economic activity. This partly explains current market discounts on PR debt, which signal potential future default and investor haircuts as part of a potential debt restructuring. Therefore, without economic growth and further budgetary progress, we can’t completely rule out a future default or debt restructuring of some sort.

Q: Is Puerto Rico a systemic risk for the market?

A: We think Puerto Rico is a potential systemic market risk. PR is one of the largest issuers in the municipal market with more than $70 billion in outstanding debt across its issuing bodies (not including unfunded pension liabilities) and is widely held. By comparison, Detroit has less than $8 billion in outstanding debt. Downgrades below investment grade could eventually lead to additional mutual fund selling, as even funds that are not forced to sell look to reduce exposure to a speculative grade credit. A future default or debt restructuring of some kind would likely do even more damage by rattling investor confidence in an asset class that has generally been seen as a bastion of safety. While the attributes of PR are not shared by the vast majority of other municipal issuers, the blow to investor confidence would likely impact all municipal market issuers.

Summing up

Investors seeking income have long been attracted to Puerto Rico bonds because of their yield potential and tax-exempt status. Most PR bonds are currently rated as investment grade, but are trading below investment-grade levels. If PR bonds are downgraded further, there will be negative financial consequences, and Puerto Rico could have considerable difficulty accessing the muni market; both of these occurrences are likely to further damage the Commonwealth’s already-tenuous financial position. Long-term solutions must be implemented to show evidence of sustainable improvement or the market may further turn away from the heightened risk of PR debt.

While Puerto Rico continues to face difficulty, largely due to its weak economy, there are varying levels of risk among the numerous issuing authorities, some of which may offer value to investors with a higher risk tolerance. Current yields for almost all PR-related securities that are now priced at below investment-grade levels may offer an attractive investment opportunity, especially if some of the reforms recently enacted take hold. Nevertheless, investors should be fully aware of the risks involved and rely on professional management and experienced credit analysts to actively monitor the situation.

*Source: Morningstar, October 2013. Past performance does not guarantee future results.

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.

Credit ratings typically range from AAA (highest) to D (lowest), and are subject to change.

 

 

 

Chad Farrington

CFA, Head of Municipal Bond Research
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