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Fixed-Income Insights

Puerto Rico might default on some of its general obligation bonds on July 1 as a last-minute rescue law passes the U.S. Congress.

On July 1, the Puerto Rican government is likely to break its constitutional commitment by not paying either interest or principal, or both, on its general obligation bonds and some other related debt obligations. Many analysts expect the government to at least pay some of the interest, but the outcome is far from clear. Although the potential for this action has been anticipated for a while, and the governor of Puerto Rico, Alejandro García Padilla, has been, for the past year, making statements about not being able to pay, the actual action of non-payment would be a significant event.

There have been movements on many fronts in recent days to respond to Puerto Rico’s situation. On June 30, the U.S. Congress passed, and the president signed the Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA), which has several features that include creating a financial oversight and management board (the Board) to oversee Puerto Rico’s finances, along with any possible debt restructurings, and a stay for a period of time restricting investors from filing lawsuits against the Commonwealth for its actions. 

While the legislation is good in creating a framework to start discussions with creditors, which have not been constructive with the Puerto Rican government, it still creates uncertainty, because the ultimate goals of the Board are not clear. The primary concern for bondholders is how the Board will handle the obligations of pensions, compared to the treatment of bonds. Also, since the Puerto Rican government would be breaking its legal agreements if it does not fully pay its debt service, the stay delays creditor lawsuits, but does not stop them from eventually occurring. Hopefully, everything will lead to Puerto Rico releasing financial statements and becoming more responsive to creditors.

Over recent weeks, most Puerto Rican bonds have rallied, for a couple reasons. One was because market participants started to anticipate that PROMESA would be passed, because the tone out of Washington was beginning to sound constructive instead of accusatory. A second reason is because the Puerto Rican government released some details of negotiations it was having with a few creditors, and the government seemed willing to agree to better terms than they had been suggesting publicly in the past. Despite the positive movement, many of the bonds are still valued at extremely distressed levels, as the outcome remains uncertain.

Going forward, after we find out how Puerto Rico will handle its bond payments on July 1, there should be plenty of action to follow in coming months. The U.S. Congress and the president will need to select the members of the Board, and this surely will be a contentious process. After they are selected, the Board’s analysis will begin and, hopefully, the goals of the group will become clear. The Puerto Rican legislature is moving toward approving a new bond deal for the Aqueduct and Sewer Authority, so if the Board does move ahead, it will be interesting to watch how the market responds.

There are still more bond payments due in coming months, so creditors will be watching to see how Governor Padilla and the Board will respond. Also, the governor’s term will be up at the end of the year, and since he is not seeking reelection, the new candidates will be campaigning, which can affect future legislation regarding Puerto Rico’s financial condition. Some of the candidates sound more favorable to bondholders than the current governor. Many want the U.S. Securities and Exchange Commission (SEC) to examine actions taken by key players in the process, so it is possible that the SEC will become involved in the Puerto Rico situation too.

Lord Abbett Investor Impact

For investors in Lord Abbett products, there will be a range of impacts. On the separately managed account side, there is no exposure to Puerto Rico, so it will not have an impact. 

For the High Yield Municipal Bond Fund, it has approximately a 6% market value exposure to Puerto Rico. Some of the Puerto Rico bonds are scheduled to pay interest on July 1, and some may not pay their scheduled interest; none of the bonds have July 1st maturities. Therefore, there are some interest payments at risk, although the holdings are diversified among a range of issuers, so many of them will not be immediately affected if interest on the general obligation and related bonds is not paid. Also, the bond price valuations are at distressed levels for many Puerto Rico bonds, so most of the impact from a potential default is likely to have been already priced in.

Our other tax-free municipal bond funds each have less exposure to Puerto Rico bonds than does our High Yield Municipal Bond Fund. Thus, we believe the impact on each such fund will be less than for the High Yield Municipal Bond Fund.

Going forward, we view the Puerto Rico situation as a long-term investment, rather than a short-term concern. Puerto Rico is a large exposure in all municipal bond market high-yield benchmarks. Although we have some Puerto Rico holdings, generally our High Yield Municipal Bond Fund is underweight the representative municipal bond benchmark, the Barclays High Yield Municipal Bond Index. Since many of the Puerto Rico bonds are valued at distressed prices, there will be volatility throughout the process, but there is potential for positive outcomes after the negotiation is finalized. As always, we will be monitoring the markets and credit situation to make sure we are appropriately positioned as the drama continues to unfold.

Daniel S. Solender, CFA, is a Lord Abbett Partner & Director of Municipal Bond Management.

 

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The Lord Abbett High Yield Municipal Bond mutual fund seeks to deliver income exempt from federal income tax by investing in lower-rated municipal bonds.

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