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Financial media outlets have been focusing upon the challenges facing Puerto Rico on the fiscal front—and in the municipal bond market—for some time now. (We examined these issues in depth in our September 19 column.) While Puerto Rico's financial situation remains difficult, there have been some positive developments since then, as highlighted by government officials in an October 15 conference call to discuss the commonwealth's current fiscal condition—and future financing plans.
Based on information gathered from the call and other sources, we present nine key factors that we believe signal potential improvement in Puerto Rico's fiscal standing—and in the prospects for its municipal debt:
1. An uptick in revenues. Based on information released by the government, as referenced in many publications, such as Bloomberg news wires, Puerto Rico's tax revenues for the first quarter of the fiscal year starting July 1, 2013, came in $10.4 million higher than projected in the annual budget and 5.5% higher than last year.
2. New bank financing. The commonwealth lined up new financing with commercial banks during October, suggesting that the government continues to have access to borrowing when necessary.
3. Better borrowing terms. To help obtain the lowest borrowing rates possible, the commonwealth's legislature approved an increase in the size of the lien on sales taxes used to support issuance of bonds by the Puerto Rico Sales Tax Financing Corp. (COFINA). Previously, Puerto Rico had allocated the first 2.75% of sales taxes to be used with senior lien and subordinate lien bonds. Now, it has allocated the first 3.5% of sales taxes to this program, allowing the commonwealth to issue more bonds supported by this tax when necessary. This direct, dedicated source of revenue will allow a new bond financing to have a higher rating and, therefore, lower borrowing costs, than their general obligation debt.
4. No need to tap a tough market in 2013. One of the primary concerns regarding future valuations of Puerto Rico bonds has been the effect that a potentially large new issue might have on bond yields given the current market environment. (Outflows from municipal bond funds have continued for 21 consecutive weeks, according to data from the Investment Company Institute.) On the October 15th call, officials stated that Puerto Rico had sufficient financing for the fiscal year ending June 30, 2014, so that it would not need to bring a new deal to market until next summer. That's important because it allows Puerto Rico to wait until market conditions are better, lessening the fear of the negative impact a large new bond issue being forced into a tough market might have.
5. Prospect of improved disclosure. A big issue for many years has been the Puerto Rican government's lack of timely or comprehensive disclosure regarding the status of its financial standing and economic health. During the October 15th call, officials agreed to provide monthly information regarding a range of financial and economic data, along with efforts to provide regular communication with investors. This should help investors to better understand the island's progress in addressing its fiscal problems.
6. A clear deficit reduction goal. Officials also stated their objective to eliminate the commonwealth's budget deficit completely by the 2016 fiscal year. The commonwealth had already taken steps several months ago to increase revenues and collections. Although they have stated this deficit-reduction objective often in the past, Puerto Rico's leaders identified their financial targets more precisely this time.
7. Sales tax support seems secure. One of the reasons that the COFINA bonds have seen their valuations fall steeply is because there has been some concern about whether the commonwealth has the ability to take away—or claw back— the sales taxes dedicated to supporting the bonds. Each time COFINA bond deals have been brought to market, the government has obtained legal opinions from the island's attorney general and private law firms to make it clear that the money cannot be clawed back. Nevertheless, there still have been concerns about potential legal challenges to those opinions.
However, during the October 15 conference call, the commonwealth officials who would be the ones to attempt to initiate any potential claw-back, once again emphasized that they cannot redirect the taxes earmarked for support of COFINA bonds even if the government wants them, because the taxes are legally dedicated towards supporting the financings. Given that the same government has decided to increase the use of COFINA for future financings, it would not have any incentive to attempt a legal challenge that would allow a claw-back, and officials have made it clear that they have no plans to do so.
8. Bankruptcy is not an option. Many have compared Puerto Rico’s situation to that of Detroit, which filed for Chapter 9 bankruptcy in July 2013. But on the call, government officials reiterated previous statements that under the Puerto Rico constitution, the commonwealth does not legally have the ability to declare bankruptcy. The commonwealth cannot utilize the option taken by Detroit and officials have no interest in trying to force movement in that direction. Officials also said that none of the commonwealth's government agencies can declare bankruptcy. That includes, bond issuers such as the Power Authority, the Aqueduct and Sewer Authority, and the Highway and Transportation Authority.
9. The debt burden may not be as big as widely believed. Puerto Rican officials continue to maintain that the island's debt burden is being unfairly—and incorrectly—compared to that of U.S. states. They maintain that a more-accurate comparison would include federal debt, along with state- and local-level debt, in calculating real debt levels. Unlike U.S. states, which have to support Federal debt, Puerto Rico does not.
Data from the U.S. Census Bureau and the Government Development Bank of Puerto Rico cited in presentation materials provided by the Puerto Rican government are instructive in this regard. For example, when counting just state and local obligations, Puerto Rico has $15,956 of debt per capita, while the U.S. average for the states is $7,355 per capita. However, if each state's portion of the federal debt is factored in, Puerto Rico stays at $15,956 per capita, while the U.S. average for the states rises to $57,024 per capita. There are different philosophies regarding how to calculate this metric, but using this method suggests that Puerto Rico does not compare as poorly as has been portrayed.
Watching and Waiting
Despite the positive factors listed above, markets appear to be taking a wait-and-see attitude. Prices on Puerto Rico municipal bonds remain depressed, although they rallied back somewhat during the third week of October. For prices to fully recover, the market needs concrete facts, rather than just projections, to confirm the trend of improvement in the commonwealth's fiscal status—and that will take some time. For example, Puerto Rico had a good fiscal 2014 first quarter in terms of revenue collections, but it needs to put together a string of positive quarters to prove that it can consistently meet its budget projections. Also, investors will be eager to verify the assertion that the commonwealth does not need to access the municipal bond market during the current fiscal year, or at least that it can wait for a better market environment to bring a bond deal.
There are a lot of indicators that investors will be eyeing in the coming months, including data on tax revenues collected, economic growth, and job creation. Also, the market will be watching for any potential new issuance of Puerto Rico municipal debt. If these factors continue to trend positively, valuations on the bonds should improve. Also, municipal bond funds in general continue to see outflows, although well below previous months. Puerto Rico's bonds could benefit from any significant recovery in the overall muni market.
So, overall, there have clearly been some positive developments for Puerto Rico, although prices on its muni bond issues have not fully recovered. More concrete evidence of fiscal and economic improvement is needed for the valuations to return to previous levels. Investors will be watching carefully, mindful that even slight improvement in any of Puerto Rico's fundamentals could present a solid opportunity for total return.
Puerto Rico bonds represent a substantial portion of municipal bond market benchmarks and we continue to believe that, at the right prices, they can be appropriate and prove to be attractive holdings for many of our strategies. We consistently review our credit opinion and market analysis to verify our decisions about our holdings, and when, in our opinion, they represent relative value, we have made, and will continue to make, investments in the commonwealth.
A Note about Risk: The value of investments in debt securities will fluctuate in response to market movements. When interest rates rise, the prices of debt securities are likely to decline, and when interest rates fall, the prices of debt securities tend to rise. A portion of the income derived from a municipal bond may be subject to the alternative minimum tax. Any capital gains realized may be subject to taxation. Federal, state, and local taxes may apply. There is a risk that a bond issued as tax-exempt may be reclassified by the IRS as taxable, creating taxable rather than tax-exempt income. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. Investments in Puerto Rico and other U.S. territories, commonwealths, and possessions may be affected by local, state, and regional factors. These may include, for example, economic or political developments, erosion of the tax base, and the possibility of credit problems. No investing strategy can overcome all market volatility or guarantee future results.
A general obligation bond (GO) typically refers to a bond issued by a state or local government that is payable from general funds of the issuer, although the precise source and priority of payment for general obligation bonds may vary considerably from issuer to issuer depending on applicable state or local law. Most GO bonds are said to entail the full faith and credit (and in many cases the taxing power) of the issuer, depending on applicable state or local law. GO bonds issued by local units of government often are payable from (and in some cases solely from) the issuer's ad valorem taxes, while GO bonds issued by states often are payable from appropriations made by the state legislature.
Senior lien bonds have the priority claim against pledged revenues superior to the claim of other obligations.
Subordinate lien bonds, also known as junior lien bonds, have a claim against pledged revenues or other securities subordinate to the claim of other obligations.
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general, nor is it intended to predict or depict performance of any investment. Investors should not assume that investments in the securities and/or sectors described were or will be profitable. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.
Investors should carefully consider the investment objectives, risks, charges, and expenses of the Lord Abbett funds. This and other important information is contained in each fund’s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional or Lord Abbett Distributor LLC at 888-522-2388 or visit us at www.lordabbett.com. Read the prospectus carefully before you invest.