With the recent collapse in the value of Puerto Rico bonds and subsequent recovery in October and November 2013, the time is ripe for a post-mortem on this high-profile bond issuer.

Puerto Rico bonds long have been a temptation to bond investors, both retail and institutional. The bonds were high yield, widely available, easily traded, carried investment-grade ratings and are triple-tax exempt* in all 50 states. About 75 percent of municipal bond funds hold Puerto Rico, and the name is commonly found in retail accounts.

Thornburg’s bond desk has distinguished itself by avoiding Puerto Rico entirely in all bond funds and separate accounts. That key credit judgment cost us some income, but has turned out to be the right call. It allowed us to avoid Puerto Rico’s recent credit crash, the liquidity crunch and the further collapse that we still see as inevitable.

A post-mortem analysis will provide insight into how Thornburg applies credit analysis to the art and science of managing risk and return to create value for our investors.

Different Types Of Puerto Rico Bonds
There are numerous forms of Puerto Rico debt. As we see it, there are some meaningful differences among the different types, but they’re all linked by common factors and risks that more or less tie them to the same sinking ship.

The flagship bond is the general obligation (GO), which has a constitutional priority over all tax revenue except the sales tax revenue pledged to the Corporación del Fondo de Interés Apremiante (COFINA) bonds. And there are several revenue bonds including the Puerto Rico Electric Power Authority (PREPA), Puerto Rico Aqueduct and Sewer Authority (PRASA),highway, transportation, pension fund, um tax, hotel tax, COFINA sales tax and a variety of lesser-known names.

From a credit perspective, the different issuers are linked by several broad factors. First, they share the same underlying weak economy and fiscal distress of the government. Second, some of them are suppliers and customers to others. The commonwealth is, for example, the single largest customer for PRASA and PREPA. And third, under the territory’s constitution, GO bonds constitute a first lien on available resources, which is commonly viewed as a first lien on the revenues that are pledged to most of the revenue bonds, including the PRASA and PREPAs.

Financial And Economic Analysis
Financial analysis of Puerto Rico is widely available, but here are the key factors as we see them:

• Weak Economy. The island economy has little activity and is highly dependent on government employment. Per-capita income is very low at $16,935, per-capita debt is high at over $50,000, and labor force participation is low at 44 percent. More than 45 percent of the population is below the poverty line. The island’s debt-to-GDP ratio grew from 60 percent in 2000 to 100.6 percent in 2012. The economy has been depressed  since 2005, shrinking from then to 2012 by 10 percent in inflation-adjusted GDP.

• Persistent General-Fund Budget Deficits. The government started running deficits in the 1980s, which have been financed with borrowed money. There is now more than $70 billion in Puerto Rico debt, for an island with a population of 3.7 million.

• Underfunded Pension Plans. The plans are approximately 6 percent funded, which is unacceptable. Recent changes are welcome, such as shifting most employees to a defined contribution plan similar to a 401(k), but it’s too late to right this ship.


For years the rating agencies have preserved remarkably high ratings on the bonds — ratings that we viewed as too high by a long shot. More than 10 years ago, we viewed all Puerto Rico bonds except the COFINAs as speculative grade, with a significant potential for payment default. This illustrates a simple component of our approach to credit risk. We look at credit ratings and read the reports, which contain some good analysis, but we form our own opinion of the risk. Often we are roughly in agreement with the rating agencies, but just as frequestly, we believe ratings are too high or too low. That ability to develop our own independent credit opinion, compare it to published ratings, and then act on our convictions is a value-creating approach to credit.

“Opportunities” Offered By The Sell Side
Broker-dealers often beat the drum of “opportunity” in Puerto Rico debt, publishing optimistic reports, listing bid/offer quotes, and disseminating trade posts that make it appear that it’s as easy to sell bonds as it is to buy bonds. In October of this year, one sell-side analyst strongly advised clients to buy the bonds, claiming “retail investors concerned with income and not prices have a sound investment in commonwealth issued debt.”

These sell-side recommendations are focused on exploiting near-term volatility rapidly paced buying and selling. At Thornburg, we’re bond investors, not bond flippers, and if you’re a long-term investor, you want to own quality bonds with healthy long-term prospects.

What If They’re Insured?
Some advisors hold insured bonds, thinking that will protect them from default, since all bond insurers except Financial Guaranty Insurance Company (FGIC) and XL Capital Assurance (XLCA) are still paying on claims. We believe that the other insurers in run-off mode — ACA Financial Guaranty Corp, Radian Group and CIFG Group — will eventually run out of claims-paying resources. And for those bond insurers that are still writing new business, such as Assured Guaranty and National Re, we are certain that this doesn’t protect the market value of the bonds prior to maturity, and we believe those insurers may incur huge claims on their portfolios that could result in down grades and run-off status. So we are sticking to our rule that we want the underlying credits in our portfolios to be healthy, even if the bonds are insured. In addition, if you approve a bond because it carries insurance from XYZ insurer, and then load up the portfolio with XYZ bonds, you end up with heavy exposure to XYZ, and diversification is the name of the game in bond investing.

Is There A Price At Which We Would Buy?
Yes. There is a price at which we would buy, and no, we will not say what that price is, except that it’s much lower than current prices. Currently most uninsured Puerto Rico GO bonds with a 5 to 6 percent coupon in 10 years are trading in the range of $75. Of course, we are paying close attention and watching every day as the action unfolds. We do expect to see further weakening and we’re content to let the market move in our direction.

Josh Gonze is a portfolio manager of the Thornburg municipal bond portfolios and a managing director of the firm. He is responsible for credit analysis for new municipal bond transactions, monitoring credit quality within the portfolios, and evaluation of sector-wide credit trends.