Puerto Rico returned to the headlines on May 1 after the commonwealth announced that it would default on $400 million in debt of its Government Development Bank (GDB). (The GDB did reach a tentative agreement with a group of investors to extend some of the bond maturities, though the complete details of the deal are not yet clear.)
This latest development in Puerto Rico’s long-running fiscal drama is receiving a great deal of attention—and, as has been the case for many months now, some political spin. As such, we think this is a good time to take a step back and review the current environment for Puerto Rico’s municipal bonds. In doing so, it is important to take emotion out of the situation in order to better understand all points of view. Here, we present nine points that should be included in this analysis.
One of the main topics that often is being reported incorrectly in the media, and stated incorrectly by some politicians to influence the outcome, relates to municipal bankruptcy, which is often referred to as “Chapter 9.” The press has reported that some politicians have claimed that they want Puerto Rico to have the same right to declare bankruptcy that the 50 U.S. states have. What is being misreported, however, is that under current law, the 50 states cannot declare bankruptcy or use Chapter 9 themselves. States, since 1937, can allow their municipalities to declare bankruptcy, but that is not possible at the state level. Repeated assertions of this claim in the media have fostered widespread misperceptions about its validity.
2) Bondholder Negotiations
The Puerto Rican government has not been actually negotiating much with bondholders. Officials have been putting most of their energy toward trying to influence the U.S. Congress (Congress) to change laws in their favor. Creditors actually have made proposals to Puerto Rico regarding concessions, but they aren’t receiving constructive responses. The Puerto Rican government has made media statements suggesting that it is trying to work with bondholders, but these mostly have been inaccurate.
It seems likely that the government will not enter into serious negotiations until it gets a clear sense of whether it can get a favorable response from Congress, or until it reaches an actual payment deadline. The U.S. Supreme Court is also reviewing a case bearing on Puerto Rico’s ability to impair bondholders; that opinion is expected to come in June. So, much of the delay in reaching a resolution is due to the Puerto Rican government waiting to see whether Congress or the U.S. Supreme Court will provide the commonwealth a stronger hand in bondholder negotiations.
3) The Financial Situation
The Puerto Rican government has not released audited financial statements for several years. The financial information that has been released to the media has not been confirmed as accurate by auditors. Some members of Congress are comfortable supporting aid for Puerto Rico without seeing independently verified information, while others are not. It is tough to take all the information the government is providing as actual facts without an independent audit, since officials are making such an aggressive attempt to have Congress change laws in the commonwealth’s favor (basically giving it different status than actual states). The government often announces that it is close to releasing years-late financials, but it has repeatedly missed its self-determined deadlines.
4) U.S. Congressional Action
Congress has been trying to draft a bill in response to the Puerto Rico situation, but both parties have been unable to come to an agreement on a final version, and many details need to be ironed out for any legislation to pass. So far, the main components of the proposed bill have been an independent financial control board similar to what some distressed cities have had in the past; a framework to more aggressively work toward a negotiated agreement with creditors; and efforts to create some incentives to boost the island’s economy. Some of the main points of disagreement are how strong to make the control board, how aggressively creditors should be forced into any settlement, and whether to constrain creditors from taking legal action against Puerto Rico. One other important consideration is what type of precedent any legislation might set in terms of addressing the troubles of other distressed municipal bond issuers. Congress already has missed various deadlines to reach an agreement, so now the timing has become uncertain, and meaningful action is unlikely to occur before major issues need to be resolved.
5) Investment Decisions
It is important to understand which factors need to be analyzed in determining whether to make investments in Puerto Rico bonds. First, it is worth remembering that the commonwealth is a significant issuer in the U.S. municipal bond market; more than 20% of the benchmark Barclays High Yield Municipal Bond Index is composed of Puerto Rico bonds. Since that index serves as the representative benchmark for many high-yield municipal bond funds, Puerto Rico is a huge part of the investible universe for those funds. Thus, Puerto Rico munis are a very appropriate and necessary investment if a portfolio remains bounded by the strategy outlined in its prospectus. An allocation coming anywhere near the actual index weighting would be considered extremely high for high-yield muni funds, but some investments in Puerto Rico are warranted for portfolios in this category.
Second, the decision to invest in Puerto Rico munis needs to be based upon current bond valuations, not the prices at which they were originally issued. Some bonds trade at 40 cents on the dollar, some at 50 cents, and some as high as 65 cents. Some issues with bond insurance are trading near par. So, given these prices and factoring in the future financing needs of the Puerto Rican government, it is very possible that there could be positive outcomes for bondholders at today’s prices. Clearly, there is a lot of uncertainty, but, we believe, the current prices reflect that.
6) Current Puerto Rico Investors
It also is clear that many muni-bond mutual funds hold Puerto Rico bonds, and many do not. This information always has been available in regular reports provided by fund companies and on their websites. Because there are a range of investor approaches toward investments in Puerto Rico’s debt, there too are a variety of opinions about how Congress and the Puerto Rican government should handle the situation. Significantly affecting these opinions are the relevant concerns of those holding the commonwealth’s muni debt, along with the potential longer-term implications the outcome of Puerto Rico’s situation might have for state muni-bond issuers in the United States. Some states are facing less dire challenges, but they are finding resistance to solutions to long-standing fiscal issues and could seek outside sources to help them in the future. There are laws restricting the U.S. federal government from interfering with some state-level laws, and that plays significantly into this topic as well. So, it is important to remember that some investors are more vocal than others and that opinions vary widely.