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Fixed-Income Insights

The commonwealth's fiscal and market challenges have been well documented, but there are several positive factors for investors to consider.

While the pain in the municipal bond market sell-off that began in May 2013 has been widespread, some issuers have suffered more than others. One noteworthy example is Puerto Rico, one of the largest issuers of U.S. municipal debt. Through August 26, the Barclays Municipal Bond Puerto Rico Index had registered a year-to-date loss of 10.80%, versus a decline of 4.88% in the broader Barclays Municipal Bond Index, according to Barclays POINT data.

But matters took a turn for the worse after a Barron's cover story (August 26, 2013) on the commonwealth's weakened fiscal situation exacerbated investor worries, helping drive the Puerto Rico index's year-to-date return down, to negative 17.6% through September 13. The sell-off has driven up yields on Puerto Rico debt, with the yield of the Barclays Municipal Bond Puerto Rico Index moving to 6.88% on September 13, compared to 3.33% for the Barclays Municipal Bond Index, according to Barclays POINT data. Yields on the Barclays Municipal Bond Puerto Rico Index and the Barclays Municipal Bond Index stood at 5.75% and 3.17%, respectively, on August 26.

The Barron's article spotlighted Puerto Rico's key challenges, which have been well known among market participants for a while: Its economy has been in recession since 2006, the unemployment rate is 13.2%, the commonwealth's budget has been structurally imbalanced for nearly a decade, and its combined debt and unfunded pension liability totals $89 billion.1 Barron's also noted that the debt per capita, at $14,000, is 10 times the average across the 50 U.S. states. Barron's did not report any new information, but summarized Puerto Rico's challenges for a wider audience at what was already a particularly anxious time for the muni market.

While the issues raised in the Barron's article were not new, the market reaction did potentially create a new problem for Puerto Rico: the prospect of reduced market access or, at a minimum, higher borrowing costs with bond prices falling. This could make it much more difficult for the commonwealth to turn to the market for financing in the future. In fact, on September 10, the Government Development Bank for Puerto Rico, which makes loans to many of the commonwealth's various infrastructure operating authorities to help them finance themselves, said it's scaling back its upcoming borrowing plans to somewhere in the range of $500 million to $1.2 billion for the rest of 2013.2 The reduction in debt issuance should benefit the market.

Amid all the headlines, what should concerned investors know about Puerto Rico's municipal debt—and the potential market impact of its fiscal challenges?

Puerto Rico's Market Presence
With approximately $52 billion in tax-exempt bonds issued as of September 2013, Puerto Rico accounts for a small, but not insignificant, chunk of the $3.7 trillion in U.S. muni debt outstanding.3 While many of the commonwealth's issuers are separate authorities with differing primary sources of revenue, the structure of the commonwealth's finances makes many of them interrelated. Historically, most Puerto Rico bonds have benefited from strong liquidity due to large issue sizes and their triple tax exemption—income from Puerto Rico municipal debt is exempt from federal, state, and local taxes in most states that have those taxes.

Puerto Rico issues all its debt at the commonwealth level, meaning that it does not have issuance at the county, city, or school district levels. As a result, financial analysis of the commonwealth's credit quality is very different from reviewing a state, because states do not borrow for local government purposes, and the local government borrowing does not factor into states' financial metrics. This borrowing feature may be causing some degree of confusion in some of the media commentary about the Puerto Rico situation, which in turn may be fostering some misperceptions in the marketplace about the commonwealth's debt levels compared with those among the states. That said, the commonwealth continues to face some serious fiscal and market challenges.

It is important to remember that despite all the headlines and market reaction, the general obligation rating on Puerto Rico is still investment-grade ('BBB-' from Standard & Poor's and 'Baa3' from Moody's, though both credit rating agencies have a "negative" outlook on the debt). Still, despite the ratings, the bonds' current market prices are reflective of a considerably lower rating.

The Market Impact
What happens next with Puerto Rico municipal bonds is in large part dependent upon the tone of the overall U.S. municipal bond market. In the broader muni market, continuing outflows from investor redemptions have prompted funds to sell municipal securities. Mutual funds are the main buyers of Puerto Rico bonds, and many, particularly state funds, already have high concentrations and constantly need to reduce their holdings as their fund sizes have been shrinking because of outflows in recent months. As sources in the media have been highlighting, many state-specific mutual funds in states with smaller issuance have high percentages of their total holdings in Puerto Rico bonds.

Without buying demand for Puerto Rico muni debt, it has become tougher for the commonwealth to access the market, which makes its cost of borrowing even higher as potential investors demand greater yields. Despite all the discussions of credit issues, a major reason why many investors may not be buying Puerto Rico muni debt, even at the current high yields, may not be repayment concerns but rather concern about potential supply of Puerto Rico muni debt in the market in coming months and how a cheaply priced new issue might affect existing holdings. One recent example of this, which may have given pause to potential investors in secondary-market Puerto Rico muni issues, is that during the summer, the Puerto Rico Electric Power Authority brought a large issue to the market, which, consequently, pushed down considerably the prices of outstanding bonds. Still, Puerto Rico bonds have already rallied somewhat off the lows following the Barron's article, but they are still not back to previous levels.

Frankly, though, the commonwealth will have a problem if it is not able to issue bonds. Puerto Rico needs to tap the muni market for at least $500 million this year and needs to be able to finance significantly more by the second half of next year, or the rates on some of its short-term borrowings will likely rise considerably. As the commonwealth has pointed out, it recently was able to line up substantial lines of credit from a couple of major banks, which it views as evidence that the commonwealth has decent market access. Still, it needs to bring bond issues to the market over the next nine months in order to pay off these lines of credit before potentially facing penalties.

Different Than Detroit
Puerto Rico is not the first muni issuer to face fiscal problems. It's worth noting that many issuers facing similar challenges have resolved their problems without harming bondholders on the general obligation level. California, for example, which in recent years saw its fiscal standing being compared with that of Greece,4 was able to strengthen its finances through new laws and taxes, and has actually had its credit rating raised by Standard & Poor's and Fitch in 2013. In the more distant past, Philadelphia during the 1990s and, more famously, New York in the 1970s were able to work their way out of financial distress via governmental oversight of their fiscal operations and new financing structures.

Some commentators have likened the Puerto Rico situation to that of Detroit, which filed for Chapter 9 bankruptcy protection in July 2013. But there are key differences. The first, and most important, is that by law, Puerto Rico cannot declare bankruptcy. Also, unlike Detroit, Puerto Rico's government has already been having some success in working through its financial issues and had been doing so well before the recent media coverage. Among the steps the commonwealth's government has taken are making substantial changes to its pension structure; developing new sources of revenue; hiring staff to enforce tax payments; and lining up private financing from banks.

Also unlike Detroit, which has been an infrequent issuer, Puerto Rico is dependent upon regular municipal bond issuance and needs to put a higher priority on market access. The commonwealth has had budget issues for a number of years, so for a while it has been depending upon access to the market to finance itself through its financial challenges. The Puerto Rico government recently has been proactive in issuing messages in an attempt to reassure the market and explain its actions in detail. While the relationship between government representatives and bondholders has been contentious in the Detroit situation,5 Puerto Rico has approached the matter in the opposite manner by holding meetings with bondholders, issuing press releases, and providing commentary to investors.

Other Positive Factors
Investors should be aware of other factors in Puerto Rico's favor. Puerto Rico currently has sufficient cash due to balances at the Government Development Bank and short-term borrowings which can keep them going without penalties until the second half of next year at a minimum.

Issuers of general obligation debt such as Puerto Rico are traditionally thought to be able to raise additional revenue or cut expenses to balance a budget even in a distressed scenario. California took both of these actions to solve its problems, although that state started with a higher rating. Solving Puerto Rico's problems in this way is more difficult, but the commonwealth has been moving in this direction. It has already initiated new taxes and is making efforts to enforce tax and fee payments across many of its authorities since it historically has had issues with making collections.

Also, many Puerto Rico issuers, such as the Power Authority and the Aqueduct and Sewer Authority, have sources of revenue other than support from the commonwealth, so even in a worst-case scenario, the potential outcomes for Puerto Rico bonds would vary considerably.

Summing Up
What are the key takeaways for investors? First, Puerto Rico and Detroit are currently facing very different situations. Dramatic headlines about the Puerto Rico situation have clearly rattled investors, who are worried about a range of issues in this environment and are having difficulty collecting all the facts.

Investors also need to analyze the extent to which Puerto Rico muni bond prices have fallen and add that as a factor in deciding whether it is a good idea to sell now. The current market price in dollars for Puerto Rico muni issues might be viewed as being low compared to the level of debt that the commonwealth can support, and the yields are well above comparably rated bonds.

At this point, the commonwealth's fiscal and debt-market issues are well recognized in the marketplace and have been for a while, well before the recent media attention. If the efforts recently put in place to ameliorate the financial situation work, the commonwealth might not be as badly off as recent articles suggest. Should fiscal pressures ease, and economic conditions strengthen even slightly, valuations of Puerto Rico municipal debt could improve substantially. Still, there are many variables at work, so investors need to be careful and make sure to keep abreast of all the information needed to make an educated investment decision.


1 Andrew Bary, "Troubling Winds," Barron's, August 26, 2013.
2 Michael Aeiro, "Under Market Pressure, Puerto Rico Scales Back Borrowing Plans," Barron's, September 10, 2013.
3 Tim McLaughlin, "Puerto Rico Debt Roils U.S. Municipal Bond Mutual Funds," Reuters, September 3, 2013.
4 Richard M. Salsman, "The Bullet Train Fiasco Reminds Us That California Is Our Greece," Forbes, July 17, 2012.
5 Carter Dougherty and Jim Snyder, "Michigan's Snyder Says Detroit's Bondholders Part of Bankruptcy," Bloomberg, July 22, 2013.

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