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Fixed-Income Insights

An in-depth look at the largest government insolvency in American history

When it comes to following Puerto Rico’s financial troubles, Lord Abbett, with one of the larger high-yield municipal bond funds in the mutual fund industry, is one of the leaders in analyzing the situation.  Lord Abbett’s investment professionals in the muni-bond sector have been quoted as experts in the financial media, and they have provided commentary to their investors for many years.  

Several members of the firm’s muni-bond group have been closely following the events as they have unfolded, including Dan Solender, Lord Abbett Partner and Director of Municipal Bonds; Eric Friedland, Director of Municipal Bond Research; and Derek Gabrish, Municipal Bond Research Analyst. They have seen Puerto Rico’s finances deteriorate for the last several years (see Chart 1), and, therefore, it came as no surprise that the commonwealth recently decided to test a new bankruptcy process, called Title III, to reduce its $123 billion in bond debt and unfunded pensions. (See Chart 2.)

“There have not been serious negotiations with creditors, so Title III was the logical next step,” Solender said. “General obligation bondholders had stated that they were getting close to an agreement with the government, but the board created last year by the Puerto Rico Oversight, Management and Economic Stability Act [PROMESA] cut off the discussions just prior to the May 1st deadline.”

While most Puerto Rico bonds have declined in value in 2017, Puerto Rico was the best performing part of the market in 2016, according to the Bloomberg Barclays Indices, so having an exposure to the commonwealth helped investors. [Still, past performance is not a reliable indicator or a guarantee of future results.]  

Following up on their recently published Muni Quarterly, Solender, Friedland, and Gabrish answered frequently asked questions about the unprecedented legal battle involving bond insurers, hedge fund creditors, mutual fund creditors, and individual investors living in Puerto Rico, not to mention law firms, public relations practitioners, and consultants.

 

Chart 1. Puerto Rico’s Economy Has Been Declining Steadily

Source: Statistical Institute of Puerto Rico and International Monetary Fund, as of May 7, 2017

 

Chart 2. Puerto Rico’s Default Was the Highest among U.S. Municipal Defaults
 
Source: Moody’s estimate for Puerto Rico based on Title III petition, as of May 7, 2017.

 

What Is Title III?
Since U.S. states and territories are not eligible for bankruptcy protection under federal law, during 2016 Congress came up with PROMESA, which had several objectives, including the establishment of a board to oversee the negotiation/restructuring process among all those who have been affected. Title III is a component of PROMESA, which gives the commonwealth the ability to restructure its debt through federal courts should negotiations fail, which they have so far.  Upon the expiration of the automatic stay on May 1, which stopped lawsuits filed against the commonwealth after the signing of PROMESA, many lawsuits were immediately filed, leading to a quick response by government to invoke Title III first for the commonwealth itself covering general obligation (GO) bonds and, later in the week, COFINA (the Puerto Rico Sales Tax Financing Corporation), covering the island’s sales tax bonds.  Title III has not been filed for the Power Authority or the Aqueduct and Sewer Authority.  Recently, both the Highway and Transportation Authority and Employee Retirement System also filed under Title III in order to restructure their debts.

How Long Will This Legal Drama Play Out?
“It could be a long process,” said Solender, “because there are several different components to it. You have the commonwealth needing to figure out how to get out of the situation in a way to grow its economy and be able to borrow in the future. You also have different creditors arguing with each other over who gets the money. There are so many parts to the process, which has to come to conclusions on topics such as how do you divide up the revenue and restructure for the future.  As a result, there won’t be just one settlement. There likely will be a lot of different settlements coming out of this.”

What Distinguishes Puerto Rico’s Troubles from Other Municipal Bankruptcies?
“Unlike Detroit, Puerto Rico’s case is more massive and more complex,” said Friedland.  “There are many sides. On one side, you have a large group of bondholders who bought GO bonds and believe that the Puerto Rican constitution protects their rights toward getting their interest paid before any other expenses. On another side, you have a set of investors who bought COFINA bonds backed by a portion of Puerto Rico’s sales tax revenue, making them believe that they have priority over that source of revenue. Trouble is, there just isn’t enough revenue to satisfy all the different types of securities. And while the sales tax group includes senior bondholders and junior bondholders, the fiscal plan that’s been proposed doesn’t make a distinction between the two. On top of all that, court filings show there’s $45 billion in unfunded pension obligations, which could also come out of this pot. There also is the potential for additional creditor fights with holders of several other types of bonds issued by instrumentalities of the government.  In comparison, Detroit had many fewer types of creditors and a much smaller amount of bonds outstanding.”

How Will This Case Be Administered?
Title III allows a federal court to determine the outcome for Puerto Rico.  U.S. Supreme Court chief justice John Roberts recently selected U.S. district judge Laura Taylor Swain to oversee the Title III cases because the government and oversight board did not reach agreement with creditors prior to the May 1st deadline for ending the stay, which had stopped lawsuits against Puerto Rico.  The judge has started hearing the cases.  Going forward, it will proceed in court and possibly outside of court, too, because the government claims that it still wants to simultaneously work toward a consensual settlement.

What Risks Do You See Going Forward?
The risk depends upon four main factors, in our opinion.  One is whether the fiscal plan created by the government and approved by the board will be followed.  This fiscal plan differed from the flow of funds created in the original bond documents by putting many expenses ahead of bondholders, including some essential and non-essential expenses.  There is, however, only so much money to go around, so the order of payment is very important.  Second, who get the sales taxes that were used to back the COFINA bonds, meaning whether COFINA bondholders retain priority or whether they are used elsewhere. Third is, where the decisions will be made?  If they are made in court, then the risk moves to the judge and will depend upon her opinion after hearing arguments.  To avoid losing control to the judge, an agreement would need to be reached out of court.  Fourth is, how long everyone is willing to holdout before reaching a final decision?  Bondholders could choose to not go along with the court agreement by appealing to other courts or the discussions in the court could drag out for a long time and be extended by any party pushing the resolution out further.

What Went Wrong with Puerto Rico’s Restructuring Efforts?
The Puerto Rican government used many strategies, which took a long time, to get the U.S. Congress to act in order to create PROMESA in 2016.  The government did not put much effort into negotiations while it was waiting for this to occur.  After PROMESA was created, the commonwealth’s government focused upon other issues, such as creating a fiscal plan, and waiting for the outcome of the commonwealth’s 2016 gubernatorial election, rather than negotiating with creditors.  Then, when the government finally had a fiscal plan, it did not follow the structure it had created for the flow of funds when it initially borrowed money to issue the bonds, so creditors had little interest in using that as a starting point for negotiations.  In the days leading up to the end of the stay, documents that were later made public suggested that the PROMESA board nixed any agreement and decided it preferred to take its chances in court with Title III.

Are There Are Any Other Complicating Factors?
The Puerto Rico constitution puts debt service for the GO bonds first, but the PROMESA fiscal plan allows many expenses to be paid before debt service.  For example, healthcare and pension expenses are sizable for the island. The fiscal plan can be amended in the future to add more funding if the federal government provides more medical care funding to Puerto Rico. “Title III is actually a mishmash of bankruptcy laws,” said Gabrish. “It’s not purely Chapter 9 [which issued by financially distressed municipalities]. It’s not purely Chapter 11 [as used by insolvent companies]. There is no precedent for a Title III case.  As you can imagine, there is a high degree of uncertainty surround the filing.  In regards to retirement liabilities for example, PROMESA mandates only that the fiscal plan for the island provide adequate funding for public pension systems.  There undoubtedly will be opposing views on what is adequate.”  (Note: Because of this uncertainty and disagreement, the judge has ruled that COFINA sales tax proceeds should be put into an escrow, rather than paid to COFINA bondholders, until the court has come to a decision on the flow of funds.  This means that neither the GO bonds nor the COFINA bonds can receive interest for now.)

What Are the Market Implications?
“The rest of the municipal bond market away from Puerto Rico has not been affected by the news, because the circumstances are unique to Puerto Rico for now, although they could affect other territories in the future,” Solender said.

According to Solender, Puerto Rico GO bonds and COFINA sales tax bonds have moved down in price between approximately 5% and 15%, depending upon the issuer since Title III was filed. Meanwhile, Puerto Rico Aqueduct and Sewer and Power Authority bonds have been relatively unchanged since May 1.

There had been news of a weak government proposal for GO bonds prior to the Title III filing, which temporarily pushed up GO bonds and moved COFINA bonds a little lower, but the market has slowly moved down since the filing.  Secondary market-trading volume has been light, although there have been trades each day.  

How Have Lord Abbett Portfolios Been Affected?
Puerto Rico is a very large component of the high yield municipal market.  As of April 28, Puerto Rico accounted for 11.9% of the Barclays High Yield Municipal Bond Index.  The Lord Abbett High Yield Municipal Bond Fund held 4.6% in Puerto Rico as of that date, a significant underweight to the benchmark.  Across Lord Abbett mutual funds with a focus on investment grade municipals, the allocations range from 0–2%, and represent reductions over the last six months.  (Lord Abbett Funds also own Puerto Rico bonds in its National, AMT-Free, Intermediate, Short Duration, Short Duration High Yield, New York, New Jersey, and California strategies. For the percentage of Puerto Rico holdings in each fund, see Table 1; for further detail on each fund, click here.)       

Are There Still Opportunities in Puerto Rico Bonds?
“Most Puerto Rico bonds are evaluated between 25 and 70 cents on the dollar, depending upon the issuer, so there is value in holding many at their current valuations based upon potential outcomes,” said Solender.

Over the past couple of years, the Puerto Rican government has made some settlement proposals for the varying issuers.  The current market levels could represent value based upon these previous levels.  Future outcomes depend upon many factors, including the direction of the negotiations, time elapsed, and flexibility of stakeholders.

As Gabrish put it, “There may be opportunities under Title III.  Just because Puerto Rico has accessed a debt-restructuring process controlled by a court doesn’t necessarily imply a worst-case outcome.  There could be an interpretation under the law that finds us in a position whereby recoveries and the pricing are better than they are right now.”

 

Table 1. Lord Abbett’s Puerto Rico Holdings, by Fund
Data as of 4/30/2017


Source: Lord Abbett.  Note: It is important to remember that these numbers include all Puerto Rico issuers, such as general obligation, Power Authority, etc.  The Fund's portfolio is actively managed and is subject to change.

 

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice.

This commentary may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

A Note about Risk: The High Yield Municipal Bond Fund, National Tax Free Fund, AMT Free Municipal Bond Fund, Intermediate Tax Free Fund, Short Duration Tax Free Fund: The value of an investment in the Fund will change as interest rates 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. High-yielding non-investment-grade bonds involve higher risk than investment-grade bonds. Adverse conditions may affect the issuer's ability to pay interest and principal on those securities. A portion of the income derived from the Fund's portfolio 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. In addition, the Fund is subject to other types of risks, such as call, credit, liquidity, interest rate, and general market risks. The Fund may invest in bonds of issuers in Puerto Rico and other U.S. territories, commonwealths, and possessions, and 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. Stockholders should consult with their tax advisor for more specific information on taxation. The AMT Free Municipal Bond Fund does not invest in any AMT triggering private activity bonds. Short Duration High Yield Municipal Bond Fund The Fund invests substantially in lower rated municipal bonds (commonly referred to as “below investment grade”, “high yield” or “junk bonds”). High-yield securities carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. High-yield municipal bonds are subject to greater risk of loss of income and principal than higher-rated securities, and are likely to be more sensitive to adverse economic changes or individual municipal developments than those of higher-rated securities. The Fund concentrates on high yield municipal bonds with shorter maturities and durations, which carry heightened credit risk, liquidity risk and potential for default. In addition, because the Fund is nondiversified, it will be more exposed to risks from a single adverse economic, political, or regulatory event than a diversified fund. A portion of the income derived from the Fund's portfolio 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. In addition, the Fund is subject to other types of risks, such as call, credit, liquidity, interest rate, and general market risks. The Fund may invest in derivatives, which are subject to greater liquidity, leverage, and counterparty risk. The Fund may invest in Puerto Rico and other U.S. territories, commonwealths, and possessions, and 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. These factors can affect Fund performance. The fund performance history at this time is very limited; therefore, performance achieved during its initial period of investment operation may not be replicated over longer periods and may not be indicative of how the Fund will perform in the future. Past performance is no guarantee of future results.

A general obligation [GO] bond 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 general obligation 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. General obligation bonds issued by local units of government often are payable from (and in some cases solely from) the issuer’s ad valorem taxes, while general obligation bonds issued by states often are payable from appropriations made by the state legislature.

The Bloomberg Barclays High Yield Municipal Bond Index is an unmanaged index consisting of noninvestment-grade, unrated or below Ba1 bonds.

The Bloomberg Barclays Municipal Bond Index is a rules-based, market-value-weighted index engineered for the long-term tax-exempt bond market.  Bonds must be rated investment-grade (Baa3/BBB- or higher) by at least two ratings agencies.  They must have an outstanding par value of at least $7 million and be issued as part of a transaction of at least $75 million. The bonds must be fixed rate, have a dated-date after December 31, 1990, and must be at least one year from their maturity date.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

The Fund's portfolio is actively managed and portfolio characteristics, such as individual holdings and weightings may change significantly over time. The portfolio data is for information only. It does not constitute a recommendation or an offer for a particular security or fund, nor should it be taken as a solicitation or recommendation to buy or sell securities or other investments. 

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 the fund’s summary prospectus and/or prospectus. To obtain a prospectus or summary prospectus on any Lord Abbett mutual fund, contact your investment professional, Lord Abbett Distributor LLC at (888) 522-2388 or visit us at lordabbett.com. Read the prospectus carefully before you invest.

Mutual funds are not insured by the FDIC, are not deposits or other obligations of, or guaranteed by banks, and are subject to investment risks including possible loss of principal amount invested. Lord Abbett Distributor LLC is the principal underwriter of the Lord Abbett Mutual Funds.

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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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