Choppy waters continue for Puerto Rican debt

Almost forty years ago, U.S. Congress passed the Tax Reform Act of 1976, a piece of legislation that essentially established Puerto Rico as a tax haven for manufacturing companies. Many companies, particularly pharmaceutical companies, took advantage of the opportunity. Unfortunately for the island, the Act expired in 2006, and since that time the Puerto Rican economy has been in a recession.

Some of the factors that have undermined the economy include a less-favorable tax environment and high operational costs, which have prompted companies to leave the island. According to estimates published in Caribbean Business, 25% of the manufacturing jobs created during the past several decades have evaporated. Other headwinds include an unemployment rate that currently stands at approximately 15%, as well as a disturbing demographic trend: Puerto Rico's aging population.

Adding to the distress is the fact that Puerto Rican youth are choosing to pursue their educations on the mainland United States, and perhaps more importantly, finding jobs here after graduation. This means that the island's tax base is degrading at the same time that the economy is in a recession; not a particularly healthy combination.

Even more pressure

Despite an administration that is trying to be transformative on the fiscal front, we believe that without a significant upturn in the economy, Puerto Rico is going to have a difficult time meeting its heavy debt obligations.

In late June, legislators enacted a law, the Puerto Rico Public Corporation Debt Enforcement Act, which allows public corporations to defer or reduce payments on outstanding bonds. This law essentially allows these entities to restructure their debt burdens by providing a pathway for negotiations with debt holders. Less than a week later, on July 1, 2014, Moody's Investors Service downgraded Puerto Rico, its agencies, and public corporations — affecting approximately $60.4 billion of debt outstanding. Moody's rationale for the downgrade was as follows:

By providing for defaults by certain issuers that the central government has long supported, Puerto Rico's new law marks the end of the commonwealth's long history of taking actions needed to support its debt. It signals a depleted capacity for revenue increases and austerity measures, and a new preference for shifting fiscal pressures to creditors, which in our view, has implications for all of Puerto Rico's debt, including that of the central government. Application of the law may further limit the commonwealth's market access, leaving it more vulnerable to financial risk and unable to fund capital projects.

The reaction to the downgrade has been decidedly negative. Puerto Rico debt has since traded down significantly and has been volatile. It's not a surprising outcome, and we are concerned that this attempt to protect the Commonwealth by “ring fencing” public corporations may have backfired (and worse, it may have jeopardized its credibility). As noted in the Moody's statement above, Puerto Rico may have impaired its ability to access the market, which could further exacerbate its debt crisis.

Our exposure

It's fair to say that we have a de minimis position in Puerto Rico issues. Aside from some pre-refunded debt and escrowed bonds, we own a single bond in the healthcare sector (a revenue bond issued on behalf of one of Puerto Rico's predominant hospitals; it is not a general obligation bond and therefore does not depend exclusively on government coffers). Other than that, we have no exposure to Puerto Rico debt.

At this writing, we are monitoring for potential investment opportunities at significantly discounted levels, but we have not participated in the market. And quite frankly, we would rather miss a rally — and pay higher prices for Puerto Rico debt — so long as we have a higher level of confidence that the debt will be serviced.

Video: A second headwind for municipal markets

In addition to Puerto Rico's teetering finances, pension deficits at the state and local level are additional sources of pressure for municipal securities. Here, Greg briefly describes his team's point of view.

The views expressed represent the Manager's assessment of the market environment as of August 2014, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.

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