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Fixed-Income Insights

Economic data and government financials continue to improve, progress is being made on deals, but there’s no end in sight for litigation or political turmoil.

(This article is from the forthcoming third-quarter 2019 edition of The Muni Quarterly.)

Since our last update on Puerto Rico, August 2018, we have continued to see strong economic data from the commonwealth as well as improvements in financial performance.

  • The Economic Activity Index, which is an on-island proxy for gross domestic product (GDP), was up 7.1% in the first 10 months of 2019. Tax revenues through April 2019 outpaced the budget by $920 million and April tax collections were up 22.2% higher than in 2018.
  • Additional disaster funding for Puerto Rico has recently been authorized by the United States congress, and includes $600 million in emergency nutritional assistance as well as a provision requiring the Trump administration to make available $8.9 billion in Community Development Block Grant-Disaster Relief funding.
  • Puerto Rico is seeing a comeback in tourism as well with independent rental volume up 72% in the first quarter of 2019 compared with the prior year and airline traffic up 24%. Cruise traffic also reached a record in 2018.
  • All told, conservative budgeting driven by the Financial Oversight and Management Board (FOMB) for Puerto Rico, U.S. federal dollars, and relief from paying debt service via bankruptcy have allowed the commonwealth to amass $13.7 billion in cash across all funds, of which roughly $7 billion sits in Puerto Rico’s Treasury. The FOMB also projects a surplus in its certified fiscal plan through 2024 if the recommended fiscal measures are taken.

Progress on Deals
Since the Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA)1 was enacted in 2016 and the commonwealth entered bankruptcy shortly thereafter, the market has seen two debt restructuring deals completed for Puerto Rico entities.

The first was a consensual agreement with bondholders of the Government Development Bank, a commonwealth lending entity. The second was a much higher profile restructuring of $17 billion in debt for COFINA,2 the entity securing on-island sales tax revenues, which resulted in a plan of adjustment and settlement in bankruptcy that gave senior bondholders new bonds at a ratio of 93% for senior bonds and 56.4% of par value for junior bonds. The recoveries were a significant improvement from trading prices following Hurricane Maria (September 20, 2018), which saw subordinate bonds trading as low as pennies on the dollar. New bonds for both of these deals have already been distributed to holders and are trading in the open market.  

Several additional agreements are now pending. The furthest along of these agreements is for the island’s power authority, PREPA,3 where 72% of bondholders have agreed to a recovery of 67.5% in new current interest bonds with a 10% “hope” note – so-called because it would only pay out after the full pay down of the current interest bonds. In addition, the FOMB has recently disclosed an agreement with roughly 10% of commonwealth debt holders that would give new bonds to commonwealth general obligation (GO) holders and commonwealth guaranteed holders in a wide range of recoveries depending on the year they were issued. Recoveries on average would be roughly 64%. The FOMB is also targeting a plan of adjustment for the commonwealth by year end which has created some urgency around striking deals despite a lack of full support from creditors and the commonwealth.

Entrenched in Litigation & Political Turmoil
The commonwealth, bondholders and the FOMB remain entrenched in litigation. For example, the FOMB has challenged the validity of over $9 billion in various debt obligations issued by the commonwealth.  The largest and arguably most important legal issue is the validity of general obligation bonds. The board is arguing that certain GO bonds issued after 2011 were issued in violation of Puerto Rico’s constitutional debt limit.  The FOMB’s recent commonwealth agreement gives higher recoveries to what they deem as legal bonds vs. bonds they have pointed out as potentially violating the constitution by being issued later than 2011.  Some bondholders have voiced concerns over the litigation and agreement and they aren’t the only ones with commonwealth leadership not supporting the most recent agreements.  The litigation has been temporarily stayed by the bankruptcy judge in an effort to encourage mediation between stakeholders.

The commonwealth and the FOMB have also been in disagreement on the fiscal plan, the budget, and the degree of the authority the FOMB has over the fiscal management of Puerto Rico. Recently, Governor Ricardo Rosselló enacted several legislative measures in defiance of FOMB objections. The FOMB warned that these legislative measures that would direct funds and benefits to pensioners didn’t comply with the fiscal plan. The FOMB also certified its own 2020 budget after Puerto Rico’s legislature was unable to submit a compliant version. Puerto Rico municipalities and the commonwealth remain poised to ignore the FOMB and proceed with the mandates of the new laws resulting in additional litigation between the FOMB and commonwealth entities.

Further complicating the situation is a scandal in the governor’s office. A recent corruption probe by the FBI led to the arrest of two former administration officials. Just weeks later, governor-appointed officials began leaving the administration, and Governor Rosselló was forced to resign following the leak of a private chat in which the governor and a group of advisors employed offensive insults and plotted to smear political opponents. The governor departed on August 2, 2019 leaving his newly appointed secretary of state, Pedro Pierluisi, the former resident commissioner of Puerto Rico, as acting governor. Pierluisi was confirmed by the House, but a confirmation from the Senate did not occur which invalidated his appointment and thus ceded the position of governor to the Secretary of Justice, Wanda Vasquez, who then stepped into the role.  Although we may see consensual deals arise, it doesn’t seem as though litigation or political turmoil will be ending anytime soon as leaders of the legislature may still challenge both the board and the authority of the new governor.

 

1The Puerto Rico Oversight, Management and Economic Stability Act (PROMESA) of 2016 is a 2016 U.S. federal law that established an oversight board (FOMB) and a process for restructuring debt, and expedited  procedures for approving critical infrastructure projects in order to combat the Puerto Rican government debt crisis.

2 COFINA (Spanish: Corporacion del Fondo de Interes Apremiante) or the Puerto Rico Urgent Interest Fund Corporation, is a government-owned corporation of Puerto Rico that issues government bonds and uses other financing mechanisms to pay and refinance the public debt of Puerto Rico.

3 PREPA (Puerto Rico Electric Power Authority) is a government owned corporation of Puerto Rico, responsible for electricity generation, power distribution, and power transmission on the island.

 

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 f or 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 f or 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 f all, 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 f actors. These may include, for example, economic or political developments, erosion of the tax base, and the possibility of credit problems.

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