Puerto Rico and Beyond: An Analysis Of The Municipal Debt Of U.S. Territories
April 3, 2014
•
David Ashley
The universe of municipal securities is vast, from general-obligation (GO) bonds backed by the full taxing power of a state, county or city, to revenue bonds funded via toll-road project payments, to everything in between. Municipal issuers are not limited to the states but also include U.S. territories such as Puerto Rico, Guam and the U.S. Virgin Islands. Puerto Rico’s high-profile fiscal struggle has been in the financial media lately. Much less well-known and reported upon are the municipal securities of the U.S. Virgin Islands and Guam. Here, we move beyond Puerto Rico and focus on all three.
Those who are familiar with Thornburg’s 30-year history as a municipal bond manager know we pride ourselves on in-depth credit research. Our view is that shareholders deserve the deepest and broadest possible credit research effort to mitigate any potential threats to net asset values. The company was founded on that principle in 1982 and we hold fast to it today.
An outline of our credit analysis of the U.S. territories of Puerto Rico, Guam and the U.S. Virgin Islands follows. We conclude with a review of the role these bonds play -- or do not play -- in the Thornburg municipal portfolios.
What Makes Territory Debt Different?
Investing in Puerto Rico, Guam or U.S. Virgin Islands debt entails both opportunity and risk. From our perspective as portfolio managers, the distinguishing factor of territory debt versus mainland debt is the extent and nature of the tax exemption extended to the purchaser. Interest on these bonds is “triple-tax-exempt,” which means it is excluded from federal, state, and local taxation, regardless of the investor’s state of residency. This provides a significant benefit to municipal bond portfolio managers and to investors. State-specific municipal funds, such as the Thornburg California Limited Term Municipal Fund, can benefit from the additional yield and diversifying credit exposure while maintaining a tax-neutral position. National municipal funds can benefit too. “Territory bonds,” as we call them, can produce this diversifying and yield-enhancing effect, but can also introduce an element of volatility, making the task of structuring a robust, diversified overall portfolio more critical to investment success.
When considering U.S. territory debt for inclusion in a portfolio, it is important that we clearly understand the risks these securities pose. The benefits are somewhat obvious, in that territory bonds offer higher yields relative to comparable mainland credits. But it is important to think of yield as compensation for risk (or even as a measure of risk) and in this case, that yield is payment for structural budget deficits, chronic deficit financing, elevated government payrolls, high energy costs and non-diversified economies. These things contribute to -- and are reflective of -- lower per capita incomes, higher debt per capita and more limited economic growth opportunities than in the mainland United States. Per capita income, direct debt and debt including pension obligations are shown in Chart 1.
Selected summary economic statistics for each of the three territories are shown in Table 2.
Territory Debt: Its Role in Thornburg Municipal Portfolios
Investing in U.S. territory debt can have its place in a well-diversified portfolio, especially one that is robustly structured to withstand the volatility and price performance of these bonds. Thornburg has not been a buyer of Puerto Rican debt for approximately 15 years. This includes all debt issued by the commonwealth or any of its many debt-issuing entities such as the Puerto Rico Electric Power Authority (PREPA) and COFINA. In our view, the pricing of the securities has not accurately reflected the risks associated with ownership. Such risks include pervasive budget deficits, pension underfunding, growing debt levels and an increasing reliance on market access to roll over previously issued debt.
With the brutal sell-off of Puerto Rican debt in June 2013, these risks have been more accurately reflected in market prices, but even at these levels, prices still remain outside our comfort level. Should prices continue to decline, we may revisit our investment thesis on Puerto Rican bonds.
Because of the enhanced yield they offer and because of our careful attentiveness to the risk/reward trade-off, we do have exposure to both Guam and Virgin Islands credits in our municipal funds. Percentages of total net assets range from 0.32% in the California Limited Term Municipal Fund to 3.27% in the New Mexico Intermediate Municipal Fund. Within the California fund, we have exposure to both Guam Power and VI excise-tax bonds. The New Mexico fund holds Guam Power, Guam income-tax bonds and VI excise-tax bonds. Our Strategic Municipal Income Fund does have exposure to Guam general-obligation debt, but in total that debt constitutes less than 1% of the fund’s assets under management. It is also the fund’s mandate to assume greater credit and duration risk, so this fits within the fund’s investment parameters. Again, such exposure should be viewed as a relatively small percentage of a diversified, robustly constructed portfolio. While none of the funds would be immune to price deterioration of either Guam or U.S. Virgin Islands debt, the holding percent relative to total fund assets would mitigate negative net-asset-value consequences.
Why does Thornburg own Guam and U.S. Virgin Islands credits but not Puerto Rico? After all, they share fiscal traits such as deficit financing and heavy reliance on federal transfers. But through fundamental credit analysis, certain mitigating distinctions can be made. For instance, in Guam’s case the U.S. military plays a key role in island finances. Besides the obvious strategic import, the U.S. military employs large numbers of military and civilian personnel and indirectly supports industries such as construction. While not party to any of the island’s debt, the military stabilizes the economy of Guam, a stability not enjoyed by Puerto Rico. The security pledge of the bonds we own (rum excise-tax bonds) is driven to a large extent by U.S. congressional re-authorization actions.
While all the territories share the same macro-level issues, at the individual security level certain mitigating factors provide adequate likelihood of repayment. We believe that we are compensated for the risks involved in purchasing the debt of Guam and the U.S. Virgin Islands. We hope this summary of our research into the creditworthiness of U.S. territory debt has provided insight into some of the work behind constructing the Thornburg municipal bond fund portfolios.
This copy is for your personal, non-commercial use only. Reproductions and distribution of this news story are strictly prohibited.