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Debt Restructuring

Impact of Puerto Rico’s Debt Restructuring on U.S. Bond Market

 

On May 3, 2017, the government of Puerto Rico requested that the Oversight Board trigger Title III, a bankruptcy-like proceeding to restructure its debt. This will be the largest restructuring in the history of the U.S. municipal bond market. A federally appointed judge will preside over what promises to be a lengthy battle between Puerto Rico and its creditors. There have been heated discussions on the potential impact these procedures will have on PR’s future access to US bond markets.

A portion of Puerto Rico’s creditors, particularly hedge funds, bought below- investment- grade bonds, assuming, correctly at the time, that Puerto Rico did not have access to bankruptcy. They knowingly purchased risky bonds in exchange for tax free bonds.

The Jones-Shafroth Act, enacted by Congress in 1917, prohibits anyone, including states, cities, and Puerto Rico itself, from taxing interest on Puerto Rican bond[1] While interest on municipal bonds issued by U.S. states and cities are also exempt from federal income tax, they are only exempt within the state of issuance. Puerto Rican municipal bonds are exempt from ALL federal, state and local income tax. This made the island’s bonds attractive to tax-averse Americans eager to shelter income. Additionally, these investments appeared to be low risk, at least until recently, due to the fact that Puerto Rico’s territorial status barred them from filing for bankruptcy.

When Puerto Rico’s financial crisis became apparent, bonds became a much less attractive option for risk-averse investors. The island’s bonds were officially downgraded to below-investment grade in 2014. During this period, most traditional municipal market investors reduced their exposure to the island’s debt, causing the territory to lose access to traditional municipal market investors. Puerto Rico’s last bond offering was in March 2014 and was sold primarily to mutual funds and hedge funds, not traditional investors.  During that quarter, 20 mutual fund families bought a combined $263 million in Puerto Rico’s junk-rated debt.

The future of Puerto Rico now depends on establishing a sustainable debt repayment plan that does not alienate the island from capital markets. The 10-year fiscal plan certified by the Oversight Board established a debt service of about 25% of the amount due. A number of creditors have argued that a corresponding haircut for debt service payments of that size is punitive, will negatively impact the market and further alienate Puerto Rico from the U.S. bond market. Their argument relies on the idea that a large haircut will lead to large losses for their companies, lead them to reduce future investment in Puerto Rican capital, and create unwillingness to invest due to distrust over possible repayment.

A Wall Street Journal analysis estimates an actual and unrealized loss of as much as $5.4 billion over the last five years for mutual fund firms who invested in Puerto Rico. However, these losses have a minimal impact for these firms, whose investments in Puerto Rico were a small part of their diversified portfolios. A closer look into the largest municipal bonds funds—Franklin, Lord Abbett, Oppenheimer and Goldman Sachs – shows minimal damage.[2] According to the article, the Franklin Federal Tax Free Income Fund (FKTIX) has over $12 billion in assets with only 0.99% invested in Puerto Rico. The fund’s three-year performance was 3.62% versus the Bloomberg Barclays Muni Bond Index of 3.55%. The Lord Abbett Municipal High Yield Bond Fund’s (HYMAX) year-to-date return is 3.51% versus the Bloomberg/Barclays High Yield Muni Index of 4.76%. The fund has over $2 billion in assets with 4.6% invested in Puerto Rico. “We have lost money but the portfolio is very well diversified, so overall shareholders have had very attractive returns over that time,” said Dan Solender, the director of tax-free fixed income for Lord Abbett told the Wall Street Journal.[3] The Rochester High Yield Municipal Bond Fund (ORNAX) from Oppenheimer, with the largest exposure at 12.4%, has a year-to-date return of 7.63%. The Goldman Sachs High Yield Municipal Bond Fund (GHYIX) was once again minimally affected, with a year-to-date return.

While the island’s debt restructuring is unlikely to affect large municipal market investors like those mentioned above, the precedent Puerto Rico sets is likely to impact its future access to the market. Smaller investors are now less likely to buy bonds from a risky issuer, regardless of tax incentive, who now has the ability to restructure its debt. Hedge funds and bond insurers have experienced a slide in shares due to their exposure to Puerto Rico. Since January 2017, MBIA has fallen 19%, Assured has fallen 6%, and Ambac Financial Group has declined 13%. While analysts have stated that these bond insurers are stable enough to weather their exposure to Puerto Rico, these insurers have been the most aggressive in agreeing to losses through voluntary negotiations.

The Ambac example is illustrative of the conundrum faced by insurers. In a recent conference call with investors, Ambac Financial's (AMBC) CEO Claude LeBlanc commented that in the first quarter of 2017 Ambac lost $169 million in its public financing division, mostly due to Puerto Rico. "The Commonwealth and the Oversight Board and U.S. Congress recognize that the precedent Puerto Rico sets with its debt restructuring now could materially and adversely impact municipal debt markets in the future. Puerto Rico is the biggest municipal bankruptcy in U.S. history and its ramifications could be far reaching," he said. LeBlanc also noted that the company’s current book value is just over $1 billion. Yet, AMBC documents published elsewhere show it has insured more than $9 billion in Puerto Rico bonds.[4]

Puerto Rico will likely regain access to the capital markets once its debt stock is once again sustainable. Many analysts argue that the island will not be able to reach stability and will remain high risk if it is burdened with unsustainable debt payments that cripple the economy.[5] The greater the haircut to the debt, the more likely Puerto Rico will be able to comply with the fiscal plan, reduce its debt burden and regain access to capital markets.


[1] Jones-Shafroth Act of 1917, Pub.L. 64-368, 39 Stat. 951, Sec. 3

[2] Gillers, Heather, and Tom McGinty. "How Big Are Mutual Funds’ Puerto Rico Losses? $5.4 Billion." Wall Street Journal, May 14, 2017. https://www.wsj.com/articles/how-big-are-mutual-funds-puerto-rico-losses-5-4-billion-1494763205

[3] ibid

[4]  Retrieve from: https://seekingalpha.com/article/4072199-ambac-financials-ambc-ceo-claud....

[5] "Puerto Rico will not see economic growth until the island sees significant debt relief," stated Eric LeCompte, Executive Director of the religious development group Jubilee USA, at the "Diaspora Summit II" organized by Centro, the Center for Puerto Rican studies based at Hunter College, on May 12, 2017.

Kathya Severino Pietri
Thursday, June 15, 2017 - 2:30pm