Promises Broken, PROMESA MadeLearn more about this firm
Island living is often likened to paradise, but on the distressed shores of Puerto Rico, the island is anything but carefree. Treading on the heels of the largest default in municipal bond history, investors are left asking, “where’s the money?”
July 1 marked the infamous day Puerto Rico missed payment on almost $800 million due on its general obligation (GO) bond debt (a municipal bond issued on good faith that the municipality will repay it by any means necessary). While their debt may be legally and constitutionally protected, the struggling commonwealth decided to maintain vital public services and pay pensioners, rather than bondholders. It’s hard to fault the commonwealth for its decision; an unenviable choice for any municipality to make.
Foresight vs hindsight
In hindsight, Puerto Rico’s default isn’t much of a surprise, with many calling it the worst kept secret in the financial industry. While hindsight is often 20/20, it’s important to note there were signs of trouble some chose to ignore. Of the few who cried “foul”, our municipal research team has warned about the risks of investing in Puerto Rico for years, saying that if investors were to own Puerto Rico, it should be in a high-yield, not investment grade, portfolio.
A look back: Insights from the team
“Concerns about Puerto Rico's fiscal health are mounting given its sizable and persistent structural budgetary imbalance, weak pension funding ratios, increasing debt burden, poor economic conditions and ongoing political uncertainty.”
- Municipal Research Team
“A closer look at Puerto Rico exposure…” Global Perspectives Blog, May 2012.
“More downside risk is possible, especially if the island loses its current investment grade rating.”
- James Dearborn, Head of Municipal Investing
“Fear is not a strategy.” Global Perspectives Blog, November 2013.
“Without economic growth and further budgetary progress, we can’t completely rule out a future default or debt restructuring of some sort.”
- Chad Farrington, Head of Municipal Research
“Trouble in paradise.” Global Perspectives Blog, January 2014.
“Current investors should brace themselves for a potentially extended period of receiving no interest income and additional price volatility.”
- Matt Stephan, Municipal Research Analyst
“Has the default train left the station?” Global Perspectives Blog, August 2015.
The fact that our municipal investors were left largely unscathed by Puerto Rico’s default isn’t the result of dumb luck. They are simply the beneficiaries of grounded research that guided our insights and recommendations.
Facing the truth
There are significant implications for asset managers who remain invested in Puerto Rico bonds. Some believe Puerto Rico will eventually repay their debts and will continue to pay out distributions to shareholders. Unfortunately, I think it’s highly unlikely that Puerto Rico will ever repay its debt, and certainly not 100 cents on the dollar.
Given this, Puerto Rico bonds are likely to be moved to a reduced- or non-accrual status, reducing the dividend paid out to investors. For asset managers who own quite a bit of Puerto Rico, this could mean reducing dividends by significant amounts, resulting in less money in investors’ pockets.
More than an empty PROMESA?
On June 30, just one day before the bond payments were due, President Obama signed into law the Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA). This law authorized the creation of a financial control board to establish a framework for a more orderly debt workout. The seven-member board will be tasked with:
Restoring Puerto Rico’s economic growth
This will help ensure that budgets are reasonable and feasible and prevent Puerto Rico’s debt crisis from turning into chaos.
Restructuring the island’s debt
This will help prevent creditors from forcing bond payments ahead of essential services. This gives the commonwealth some breathing room to try to come up with a viable debt repayment plan.
I’m hopeful the board can help turn the crisis around, but think the public’s shared optimism of the control board may be unrealistic. While it provides oversight, it’s not a complete solution, offering little consolation to current debtholders. It’s important to know what PROMESA is but it’s equally important to know what PROMESA isn’t.
- It is NOT a bailout. Just so we’re clear, the legislation is not a bailout and doesn’t call for using taxpayer money to help Puerto Rico repay its debt.
- It is NOT a source of revenue. The board doesn’t bring any money to the table, and doesn’t directly improve Puerto Rico’s economy. Given Puerto Rico’s flagging economy, it’s hard to imagine how they could repay anything without significant revenue growth. Unfortunately, one of the most alarming statistics is the troubling out-migration of the island’s citizens, particularly the young and professional workforce. This professional exodus is leaving behind a shortage of pediatricians and available medical care and ultimately leaves the island less able to generate organic economic activity, which doesn’t bode well for future revenue collection.
- It is NOT an invitation to sue Puerto Rico. When people feel they are owed money, many pursue legal recourse. PROMESA actually puts a halt on that type of lawsuit. This is disappointing for some hedge funds who’ve been pushing hard to hold the island’s feet to the fire and make them pay their debt. Not to be deterred, a group of hedge funds sued Puerto Rico last week on the grounds that it violated PROMESA – the very legislation meant to dissuade this type of legal action.
Under PROMESA, it is possible that the federal government will look at non-monetary measures that would benefit Puerto Rico. For example, the Jones Act, which regulates shipping and limits Puerto Rico’s ability to serve as an import/export hub of the U.S., could be amended. We’ve seen how powerful these types of regulatory changes can be, but in reverse like when the end of a federal tax break accelerated Puerto Rico’s decline in the 90s. Section 936 of the tax code allowed pharmaceutical manufacturers to relocate on the island and receive favorable tax treatment—that is until it was struck down in 1996 and phased out over the next decade, coinciding with Puerto Rico’s economic decline.
Throughout Puerto Rico’s extended default saga, the municipal market has proved its resiliency. The severity of Puerto Rico’s fiscal problems has been well-chronicled, yet despite negative headlines the default didn’t trigger any increased volatility in the broader municipal bond market. And in a climate where market events seem to be met with surprise more often than not, resiliency is a quality we can all appreciate from our municipal bond investments.