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Puerto Rico's Challenge - 2013
Puerto Rico's Challenge - 2013
Puerto Ricos debt has long been attractive to municipal investors. The Commonwealths bonds carry high yields and are exempt from local, state, and federal income taxes. However, the Commonwealth today is flirting with insolvency, and the risk is growing that someday, Commonwealth investors may not be repaid, in full. Puerto Ricos financial condition is far worse than any U.S. states, and a default though unlikely in the immediate future is a possibility over the next few years. Breckinridge has long avoided obligations of Puerto Rico, but we believe all municipal bond investors should now be cognizant of its problems. A Commonwealth default would have significant ramifications for the municipal market. In this Special Commentary, we introduce the Commonwealth and its financial situation, and we speculate on the market impact of a Puerto Rico bond default. Our discussion begins with a brief introduction to the Commonwealths governance, the status issue, and its economy. It next moves to an overview of the islands poor financial condition. We then discuss how recent reform initiatives coupled with the lack of a trigger event make a default unlikely, at least in the near term. We conclude with a discussion of such a defaults impact on the market and the legal precedents that might emerge from it. advisor, and primary lender to the Commonwealth, its political subdivisions, and its public corporations. Puerto Ricos growth and financial stability require a healthy GDB.
Economy
The Puerto Rican economy entered recession in late 2006, and it has yet to emerge. Rising oil prices, government downsizing, and the end of tax advantages for manufacturers were the immediate causes of recession. 5 The Great Recession compounded the islands problems.
Puerto Ricos Real GDP Growth has been Negative or Modest for Several Years
Source: Government Development Bank for Puerto Rico
1.0% 0.5% 0.0% 0.5% 1.0% 1.5% 2.0%
2006
2007
2008
2009
2010
2011
Forecast
2012
200 High Street, Boston, MA 02110 Ph: (617) 4 43 - 0779 Fx: (617) 4 43 - 0778 w w w.bond inve stor.com
Source: Official Statements, Public Improvement Refunding Bonds, Series 2012A, p. 113, February 1,2012 and Government Development Bank for Puerto Rico, Senior Notes, Series 2011A, p. 1-2, February 12, 2011.
$0 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11
Inflexible Debt Structure: Puerto Ricos debt structure is less flexible than other municipal issuers. The Commonwealth repays only 21% of its debt within 10 years.15 This means there is little potential to free up cash by extending maturities through refinancing. Politically Weak Bondholders: Relatively few Puerto Ricans own the islands bonds.16 Municipal debt is typically owned by resident taxpayers who pressure their politicians to avoid bond defaults, but Puerto Ricos creditors have a more limited voice in its politics. Poor Forecasting: Puerto Rico consistently adopts aggressive economic and financial forecasts. The Government Development Bank has missed economic growth forecasts for three consecutive years.17 Politicians continue to tout progress on relatively weak financial and economic data.18
-$500
-$1,500
-$2,000
-$2,500
Source: Government Development Bank and Official Statements from bond offerings.
-$3,000
-$3,500
Deficit Financing: The Commonwealth has issued debt to finance its annual deficits. Unlike healthy municipal issuers, the Commonwealth requires market access to meet payroll and other obligations.
200 High Street, Boston, MA 02110 Ph: (617) 4 43 - 0779 Fx: (617) 4 43 - 0778 w w w.bond inve stor.com
Recent Reforms and Lack of a Trigger Event Suggest a Near-Term Default is Unlikely
Despite its poor economic and financial profile, the risk of a near-term default by Puerto Rico appears slim. Recent reforms appear sufficient to delay (if not forestall) a default. Equally important, the trigger events most likely to induce a Puerto Rico default seem unlikely.
Reforms
The Commonwealth has implemented a series of financial reforms during the past two years that have positively impacted its credit quality and growth prospects. These reforms (outlined below) include: overhauling the tax system, 27 streamlining the islands licensing and permitting process, 28 reducing government expenditures, 29 establishing a framework for public-private partnerships (essentially privatization of state assets), 30 and several changes to the pension system. 31
Puerto Rico has Enacted Several Important Fiscal Reforms over the Past Two Years
Jan-09 Feb-09 Mar-09 Apr-09 May-09 Jun-09 Jul-09 Aug-09 Sep-09 Oct-09 Nov-09 Dec-09 Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Dec-10 Jan-11 Feb-11 Mar-11 Apr-11 - Reduction of corporate and individual income tax rates, enhanced tax compliance, and reduction in tax credits and exemptions to spur growth and increase tax collections. (Acts 154/171, November 2010. - Establishing an early retirement incentive which had a positive effect on pension systems actuarial value. (Act 70, July 2010) - Creation of a new energy policy to reduce dependence on costly oil and foster renewable energy technologies. (Acts 82/83, July 2012) - Overhaul of burdensome licensing and permitting processes to stimulate growth and entrepreneurship. (Act 161, December 2009) -C reation of a public-private partnership mechanism (effectively a privatization law) to raise cash and restructure the management of state assets. (Act 29, June 2009) - Gradual reduction in operating expenditures (Act 7, March 2009) - Imposition of temporary and permanent tax hikes (Act 7, March 2009)
Note: Figures are for 2010. Data for California reflects plans for state employees, only, and excludes teachers and public agency employees. Excludes pension reforms made for fiscal years beginning after June 30, 2010 Source: Merritt Research Services, LLC
100%
90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 14% 45% 61% 53% 71% 63%
May-11 Jun-11 -I mmediate capitalization of pension funds with $163 million from the Commonwealths Infrastructure Financing Authority. (Act 96, June 2011) -L ower the maximim amount a member can borrow from the employees retirement system pension fund from $15,000 to $5,000 to improve the systems liquidity. (New regulation enacted by the Board of Trustees of the Employees Retirement System, August 2011)
Jul-11 - Increase in employer contributions to the pension system (Acts 114/116, July 2011)
Puerto Rico Illinois Connecticut Rhode Island California New Jersey
Trigger Events
Importantly, the events most likely to set in motion a default seem unlikely in the near term. These mostly include risks associated with Puerto Ricos dependence on the capital markets and federal government. Because it borrows frequently to fund operations, the Commonwealth must retain market access to avoid a bond default. A ratings downgrade, the elimination of the tax-exemption for municipal bond interest, or an increase in mutual fund redemptions would threaten this access. However, all three of these events seem unlikely: R atings Downgrade: Puerto Ricos ratings of Baa1/BBB are barely investment grade. A downgrade could force some selling and significantly limit demand. Fortunately, this scenario is unlikely in the near-term insofar as rating agencies generally give struggling issuers time to implement planned reforms. E limination of tax-exemption: Federal tax exemption has supported retail demand for Puerto Ricos bonds, which are exempt at the local, state, and federal level. Without this triple tax-exemption, Puerto Ricos cost of borrowing would rise, as would the risk of a failed bond sale. Fortunately, federal lawmakers seem aware of Puerto Ricos dependence on triple-taxfree bonds, 34 and are unlikely to invite a default by pulling the subsidies for its debt M utual Fund Redemptions: Many state-specific mutual funds are large buyers of Puerto Rico bonds, and they have supported the market for Puerto Ricos debt quite well. Strong mutual fund inflows in recent years have given these funds the capacity to do so. However, when interest rates begin to rise, these funds may enter a prolonged period of redemptions and their capacity to keep buying Puerto Rico bonds may diminish. If those redemptions coincide with further deterioration in Puerto Ricos credit quality, mutual funds could become sellers rather than buyers. A debt crisis in Puerto Rico might also ensue as a result of federal government austerity measures. Cuts to Puerto Ricos transfer payments and the end of favorable corporate tax treatment could significantly impact the islands credit profile. However, we believe the negative effects of these austerity policies are unlikely to materialize in the near future. F ederal government cuts to Puerto Ricos transfer payments. Puerto Ricos citizenry depends heavily on federal government transfer payments, including those for food stamps, Medicaid, and social security. However, the federal government is unlikely to cut these programs independent of a wholesale reform, and there are only modest savings to be generated by reducing payments to Puerto Ricos residents. J ob losses associated with the end of the preferential corporate tax treatment. Congress ended the Section 936 preferential tax treatment
Conclusion
Although the threat is not imminent and the risk remains slim, Breckinridge believes the possibility of a default by Puerto Rico is sufficient to warrant the attention of municipal investors. A Puerto Rico default would have negative market implications. High grade investors should understand the Commonwealths fiscal problems because a default might trigger mutual fund redemptions and bouts of illiquidity. However, Puerto Ricos debt situation is unique and unparalleled in the United States. A debt crisis in Puerto Rico will have limited impact if any on the extremely remote likelihood of a U.S. state default. We end with a graph that illustrates just how different Puerto Rico is compared a distressed U.S. state: Illinois. Illinois compares very favorably even though it faces several years of large structural deficits and large pension and retiree healthcare liabilities.
* Includes revenue debt and state guarantees GSP = Gross State Product Source: U.S. Bureau of Economic Analysis, Puerto Rico Planning Board, and Comprehensive Annual Financial Reports, Illinois and Puerto Rico, FY 2010.
Puerto Ricos Economic and Fiscal Condition Compares Poorly Even to Illinois
Illinois Population (millions) 13 % of Population Employed 47% GSP per capita $50,938 Bonded Debt*/GSP 4% Unfunded Pension & Retiree Healthcare 16% Debt/GSP Cumulative General Fund Deficit (FY 10) -16% Federal Aid as % of Budget 30%
DISCLAIMER: The material in this document is prepared for our clients and other interested parties and contains the opinions of Breckinridge Capital Advisors. Nothing in this document should be construed or relied upon as legal or financial advice. All investments involve risk including loss of principal. An investor should consult with an investment professional before making any investment decisions.