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Fixed-Income Insights

During the first half of 2018, bonds from Puerto Rico’s municipal issuers have posted some sizable returns.

(Note: This article is from the forthcoming edition of The Muni Quarterly.)

In the aftermath of Hurricane Maria in 2017, prices on the various bonds issued by the Commonwealth of Puerto Rico and its related agencies' enterprises had fallen by more than 60%. Headlines regarding the significant damage inflicted upon the power system and other key infrastructure filled the media. Yet, during the first half of 2018, bonds from Puerto Rico’s municipal issuers have posted some sizable returns, which might be a surprise, given all the negative news that continue to emanate from the commonwealth.

Other than the Aqueduct and Sewer Authority (PRASA), which is still paying interest, all other uninsured Puerto Rico bonds remain in default. But that hasn’t stopped Puerto Rico’s bond prices from moving higher. For example, subordinate COFINA sales tax bonds started the year trading at $10 for every $100 of par value, but since then, they appreciated to $42.75 for every $100, as of July 3, 2018. That is a return of more than 300%. (COFINA is the Corporación del Fondo de Interés Apremiante—a government-owned corporation of Puerto Rico that issues government bonds.) Senior COFINA sales tax bonds started the year at $40.15, and, as of July 3, 2018, were trading at $85.25—a return of more than 100%. The general obligation bonds that were sold in 2014, which was the last new issue from Puerto Rico, started the year at $23.75, and were trading at $39.50, as of July 3, a return of roughly 75%. The PRASA bonds started the year at $61.63, and recently were priced at $70.88, representing a price return of nearly 15%.

 

Fundamental drivers have made investors more optimistic on Puerto Rico’s recovery prospects.

 

So, what is driving the rally?

Despite the appointment of a fiscal control board in 2016, it is important to point out that Puerto Rico still remains in the middle of a financial and legal storm. There is significant litigation pending, and most public agencies and bodies, including the commonwealth itself, are tied up in bankruptcy proceedings. Yet aside from technical aspects of the market, there are some fundamental drivers that have made investors more optimistic on the recovery prospects for Puerto Rico and its bonds. These developments include the potential for federal funds flowing into Puerto Rico, allowing for upward revisions to surplus projections; strong cash balances for the government due to better-than-expected tax revenues; the repowered energy grid, which has resulted in residents returning to the island; and the fact that some stakeholders are resuming negotiations.

Federal Funds: Timing Uncertain
The changes to aid, and the impact of the hurricane, forced the fiscal control board to redevelop its fiscal plan, which it had certified in the spring of 2017. In the latest version of the board’s certified fiscal plan, total aid and insurance proceeds are estimated to put $62 billion back into Puerto Rico’s economy, which is a conservative estimate, compared with Puerto Rico’s median estimates of $97.4 billion. Thus far, the commonwealth has been specifically allocated more than $32 billion through various spending packages. Prior to the hurricane, Puerto Rico’s fiscal plan projected a cumulative operating surplus before debt service of $4.5 billion from 2018–23. Post-hurricane, that surplus increased. The fiscal control board certified an amended plan on June 29, 2018, with a projected surplus through 2023 of $6.6 billion, resulting in part from the anticipated federal funding.

Cash Balances: Stronger Than Expected
As the U.S. federal government became more and more active on the island, and federal loans became a hot topic, Puerto Rican government officials began to reveal cash balances that had been, up until then, a mystery. In December 2017, Puerto Rico announced that it had $6.8 billion in previously undisclosed government bank accounts, which amounts to nearly two years of debt service on tax-supported debt. That number has since grown to more than $9 billion, as of July 2018. Growth in the cash balance has been driven in part by better than expected revenues as well as temporary relief from paying debt service on bonds as provided by the bankruptcy court. In December 2017, the administration estimated revenues were down by as much as 25%. Contrary to forecasts, general fund revenues, through May 2018, were down only 2% year over year.

Power Back On: Residents Returning
After many glitches and a slow start, the island’s electric system has been restored. Data also indicate that during the first half of the year, island residents began returning on a net basis. Flight data show that roughly 200,000 people left via plane during the period September to December 2017. From January to April 2018, approximately 72,000 people arrived on a net basis. This is in stark contrast to original commonwealth estimates of 250,000 net departures.

Creditor Negotiations: Discussions Resumed
When the hurricane hit the island, creditor negotiations were derailed. One of the major points of contention for Puerto Rico bondholders continues to be the ownership of the sales tax revenue pledged to COFINA.  The battle for funds between the general obligation and COFINA bondholders has been playing out in the Title III court presided over by Judge Laura Taylor Swain. In 2017, two agents representing the commonwealth and COFINA were assigned to be non-partial representatives of the fiscal control board.  Following the disclosure of negotiations between two competing bondholder groups, one holding general obligation bonds and the other COFINA bonds, a settlement was crafted between the board representatives of the commonwealth and COFINA. The settlement gives the commonwealth access to 46.35% of pledged revenue to COFINA. Although the control board and commonwealth have yet to weigh in on the settlement, Judge Swain granted an abeyance in order to provide more time to complete the settlement. The settlement between the agents also prompted discussion between senior and subordinate COFINA bondholders who would be affected by the settlement. No agreement was reached, however, and the settlement agreement remains a long way from being finalized through a plan of adjustment. However, market participants have been seemingly encouraged by the discussions over the past few months.

In addition to COFINA discussions, it recently was disclosed that the Puerto Rico Electric Power Authority (PREPA) had reached a tentative deal with an ad hoc group of bondholders and the fiscal control board that would result in an exchange of bonds at a discounted rate for new bonds. The discount would be greater than a prior agreement between PREPA and bondholders that initially was rejected by the board, but substantially above trading prices for uninsured debt prior to the announcement. The release of the agreement resulted in a substantial increase in PREPA bond prices in late July 2018. It is important to note that the deal remains subject to finalization and court approval, and like prior deals there is the possibility that it could be changed or unwound.

If we look to the future, pending negotiations among creditors, the commonwealth, and board and court representatives may have the potential to deliver bond price-restructuring outcomes that are much better than the worst cases that investors might have expected.

 

IMPORTANT INFORMATION

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.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.

This material is provided for general and educational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, or any Lord Abbett product or strategy. References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice, and should not be used as the basis for any investment decision. This is not a representation of any securities Lord Abbett purchased or would have purchased or that an investment in any securities of such issuers would be profitable.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

A Note about Risk: The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The municipal bond market may be impacted by unfavorable legislative or political developments and adverse changes in the financial conditions of state and municipal issuers or the federal government in case it provides financial support to the municipality. Income from the municipal bonds held could be declared taxable because of changes in tax laws. Certain sectors of the municipal bond market have special risks that can affect them more significantly than the market as a whole. Because many municipal instruments are issued to finance similar projects, conditions in these industries can significantly affect an investment. Income from municipal bonds may be subject to the alternative minimum tax. Federal, state and local taxes may apply. 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.

The credit quality of the securities in a portfolio are assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor's, Moody's, or Fitch, as an indication of an issuer's creditworthiness. Ratings range from 'AAA' (highest) to 'D' (lowest). Bonds rated 'BBB' or above are considered investment grade. Credit ratings 'BB' and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer's ability to pay interest and principle on these securities.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

The opinions in this commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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