PMC Weekly Review - July 17, 2015

Puerto Rico’s Municipal Bonds – An Uncertain Future

In late June, Puerto Rico’s Governor Alejandro Garcia Padilla announced that he believes the island’s current $72 billion in outstanding debt is “not payable” and is seeking to negotiate with current bondholders either to suspend interest and principal payments or restructure the debt. The announcement followed the release of the Krueger report, researched and written by three former IMF officials at the request of the Puerto Rican government, which also called for restructuring the existing debt. It is highly uncertain how the government proceeds from here and what this means for the debt holders.

At $72 billion, Puerto Rico’s debt per capita is higher than any other state or territory in the U.S., and more than three times the $20 billion in debt that Detroit faced when it filed for bankruptcy. Since being elected in 2012, the Governor has worked with the Legislature to implement a number of austerity measures. These include barring state agencies from paying employees for accrued sick days, cutting Management and Budget Office expenses by 30%, across the board and restructuring public sector pension funds to encompass later retirement ages and higher worker contributions. The government also raised water and sewer rates by 60%, and tripled the excise tax on gas and oil. These measures have not been enough, given a 12% unemployment rate and a shrinking populace (and tax base). The island’s population fell by 5.5% from 2004 to 2013, and was projected to fall by another 0.7% in 2014, according to the Federal Reserve Bank of New York’s 2014 report. The expiration of corporate tax breaks in 2006 prompted many of the manufacturing and pharmaceutical companies to leave the island, kicking off a near decade-long recession. Laws mandating the use of U.S. flagged and crewed cargo ships keep the cost of importing goods, particularly oil, higher than in most mainland U.S. states.

Concurrently, Puerto Rico’s status as a commonwealth precludes its government from using the protection of the Chapter 9 bankruptcy codes afforded to Detroit, Michigan and Stockton, California. A bill has been introduced in the House to give Puerto Rico that protection, but the chances are slim the bill will advance or be passed in the House. Viewing the bankruptcy protection as a back-door bailout of the island, the Republican leadership is very much opposed to the idea. Several large institutional debt holders have made direct overtures to the government to lend additional funds, but reportedly have been rebuffed. Two of the mutual fund families with the largest stakes, Oppenheimer Funds ($4.5B) and Franklin Templeton ($2.3B), recently won a lawsuit declaring the debt restructuring act passed in 2014, allowing the commonwealth’s public corporations to restructure its debt and overhaul its labor contracts, was unconstitutional. Both firms continue to insist Puerto Rico has the ability to pay its existing debts, pointing to comments made by Treasury Secretary Juan Zaragosa indicating the government has sufficient funds to service the debt, but prefers to direct those payments to programs to stimulate economic growth.

Without the structure of a bankruptcy proceeding, what happens next is unclear. Puerto Rico made its debt service payment on July 1st, but failed to make a $94 million payment due this week. Further missed payments likely will force the issue into the courts, but the outcome of any trial is questionable, and would likely be both time consuming and highly expensive for all parties. Structuring a comprehensive deal that will put the commonwealth on its preferred path forward would be incredibly complex, given the broad and diverse range of issuers and individual bond issues outstanding not to mention the diversity of the bond holders. Also factoring into the equation are the three large U.S. bond insurers, Assured Guaranty, MBIA, and Ambac Financial Group, who collectively back roughly 20% of the outstanding debt. Even if such a restructuring could be done, it would have the secondary effect of making any new issuance in the foreseeable future very expensive, if not closing the capital markets for Puerto Rico altogether.

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