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Fixed-Income Insights

Here, we offer some important context for investors following the recent volatility in the commonwealth’s municipal bonds. 

 

In Brief

  • Puerto Rico’s municipal bonds came under increased pressure on October 4, following a suggestion by U.S. president Donald Trump that the hurricane-wracked island’s debt should be “wiped out.”
  • While the notion was downplayed by the White House budget director, the news still unnerved muni-bond investors.  
  • Unless there is unprecedented change in the U.S. legal system, Puerto Rico’s debt cannot simply be forgiven. 
  • Aid from the federal government should be a positive for Puerto Rico, in terms of rebuilding and, ultimately, supporting economic growth.
  • However, due to the impact of Hurricane Maria, the focus on regaining essential services such as power and water likely will delay debt restructuring.
  • It is in the best interest of the Puerto Rican government to work out reasonable deals with bondholders, given the island’s likely need for additional financing via the credit markets.
  • The key takeaway: While the first priority is making sure the island’s population recovers from Hurricane Maria, Puerto Rico and its creditors will have to tackle its difficult financial situation. We believe, however, that there is still reason for hope in that regard.

 

Puerto Rico’s municipal bonds, already under stress from the island’s ongoing financial crisis and the devastation wrought by Hurricane Maria in September, suffered a fresh bout of volatility on October 4. On the previous day, U.S. president Donald Trump, touring the island for a firsthand look at relief efforts, suggested that the island’s debt should be “wiped out,” though the White House management and budget director, Mike Mulvaney, downplayed the possibility in a statement he read the next day.1

The news caused prices on municipal bonds from Puerto Rican issuers to fall sharply on October 4, though they recovered from session lows. Puerto Rico’s benchmark 8% general obligation bonds due 2035, which started the session at a price of $44, traded as low as $32.50, before bouncing back, to $37.875, on October 5. Bonds from various Puerto Rican issuers already have been under pressure since the hurricane struck on September 20, due to higher probabilities of weaker outcomes for bondholders owing to the extreme stress on the commonwealth’s economy.

Unless there is an unprecedented change in the U.S. legal system, the federal government cannot wipe out the island’s debt. Even Mulvaney said "not to take the president's suggestion literally." Clearly, the hurricane has made the island’s financial recovery efforts more difficult, and bonds have traded down sharply in response, but forgiving the debt is not really an option.

Right now, Puerto Rico’s chief priority is restoring essential services to residents and businesses, so it will take some time before investors get back to focusing on restructuring the island’s debt. There is, however, a positive in the works for Puerto Rico, in that the federal government will be providing a lot of money for rebuilding efforts, especially in the absence of such assistance during the island’s financial difficulties of the last few years. Still, Puerto Rico most likely needs private investors, who will require clarification about their current legal standing in order to be willing to lend them more. Such investors should continue to have some legal protection under the terms of the current debt agreements—which the island’s government helped establish when it borrowed the money—although, ultimately, the courts may need to make decisions regarding the inviolability of the protection.  

The concerns now are what will the restructuring look like and how long will it take to develop an agreement. When conditions improve to the point that the process can restart, there are many legal decisions that need to be made by the court, unless the Puerto Rican government and the board of the financial oversight body established by PROMESA (Puerto Rico Oversight, Management, and Economic Stability Act) are willing to start negotiations. Also, the timetable for the discussions and the potential economic recovery could be extended owing to the effects of the hurricane. Ideally, there will be pressure to move the process faster now, because Puerto Rico needs financing beyond amounts provided by the federal government, and the commonwealth’s leadership may find outside investment difficult to obtain if it pursues weak deals for creditors that could be challenged in court for years.  

All in all, it’s a very tough situation for Puerto Rico and investors alike. Clearly, getting the island back on its feet is job number-one. Taking care of its current and future financing needs, while protecting the rights of bondholders, will prove challenging. Meanwhile, we believe there is still hope that things will improve from here on forward.

 

1Justin Sink and Jennifer Epstein, “No U.S. Bailout for Puerto Rican Debt, Trump’s Budget Chief Says,” Bloomberg, October 4, 2017.

 

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