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Puerto Rico munis: Risks increase

Puerto Rico's latest laws have raised fears among muni bond investors.

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Puerto Rico’s municipal bonds have sold off dramatically over the last 18 months, as investors have been spooked by repeated downgrades, a moribund economy, and shaky government finances. The island’s bonds took another dive in June, following the enactment of a new law that paved the way to restructure the debt of public corporations. Viewpoints spoke with Fidelity Capital Markets Market Strategists Tom DeMarco, CFA, and Ilya Perlovsky, CFA, to better understand the backlash against the new law and the state of Puerto Rico’s municipal bond market.

What caused the recent sell-off in Puerto Rico debt?

DeMarco: On June 28, 2014, the governor signed a bill called the Puerto Rico Public Corporations Debt Enforcement and Recovery Act. The law establishes a process for a controlled restructuring of public entities’ debts, and is supposed to free the General Fund from the obligation to back them. It is important, because public corporations such as the Electric Power Authority and the Highway and Transportation Authority are heavily indebted. The act would affect approximately 30% of Puerto Rico’s overall debt load.

The act has caused a lot of angst in the municipal market, because investors fear the next step will be a restructuring and are worried about how secure the rest of the Puerto Rico debt complex truly is. Since the law was enacted, the rating agencies have issued a slew of downgrades across all Puerto Rican credit, and the island’s bonds have plummeted in value. The S&P Municipal Bond Puerto Rico Index dropped just under 10% from June 2 to July 8, 2014. The index has since recovered about 40% of that drop.

The Puerto Rico government says it’s simply trying to make the public corporations more self-sufficient. The government had enacted prior legislation toward that goal, and I think they viewed this new law as an extension of those previous efforts. They seem a bit surprised that the market reaction has been so negative.

For their part, investors seem to be thinking that if the Puerto Rico government is willing to rewrite bond contracts on these corporations, then it could just be a matter of time before they decide they have to do it on the whole Puerto Rico complex. Two fund companies, OppenheimerFunds and Franklin Templeton Investments, filed suit to strike down the legislation as soon as it was signed. So there are still a lot of unknowns, and the situation could take a lot of twists and turns before all is said and done.

How does the fiscal picture look?

Perlovsky: I think that they are going to finish the fiscal year roughly where they expected they would, with little to no General Fund deficit. That’s a big improvement from the nearly $3 billion deficit Puerto Rico had in 2009.

They managed to balance the budget in part by increasing some taxes while cutting expenses and consolidating interdepartmental budgets. These moves have been painful in the short term, but they could improve the island’s economy in the longer term.

However, when you sharpen your pencil and dig into the numbers you see that the government was able to balance the budget only because it issued new bonds in March and used some of the proceeds to service its debts for the current fiscal year. And the government plans to come back to the market in the next few months with tax and revenue anticipation notes (TRANs), essentially short-term bonds that would help them bridge the gap between near-term expenses and tax revenues expected later in the fiscal year. There is also news of Puerto Rico legislators working on a plan to allow the Puerto Rico Infrastructure Financing Authority (PRIFA) to sell as much as $2.2 billion of bonds backed by petroleum-tax revenue to repay loans to the Government Development Bank. So, while I think it’s positive that they’ve stabilized their budget situation, the question is, can they maintain it?

DeMarco: There remain some unresolved issues, for instance the retirement system.

Perlovsky: They were able to restructure the public employee retirement system, which is positive. But it looks like they have to go back to the drawing board on some of the reforms that they tried to implement in the teacher’s retirement system. The overall result is that the burden on the General Fund will increase in the coming years but decrease over the long term.

What about the economy?

DeMarco: There are signs that economic conditions may be improving. Puerto Rico’s Economic Activity Index was down 1.3% year over year in May. That’s weak, but it’s much better than the 4.3% 12-month decline it had in December last year.

But at some point the economy needs to generate some positive momentum to produce the tax revenues the government needs to service its debts, and from what I can tell it’s still not happening. There are some potentially encouraging signs, but it’s far too early to say whether they’re likely to generate the growth the island needs. Puerto Rico is still losing about 750 people per week as residents move to the mainland. These are typically younger people, so this migration is worsening the island’s demographics.

The government is trying to boost the economy by attracting investors. They have created special areas of development to court new businesses—hedge fund manager John Paulson hosted a big event earlier this year. And they have attracted hedge fund investment to the island. Whether these efforts will translate into actual growth for the island is anyone’s guess.

What does it all mean for investors?

DeMarco: I think investors need to be paying attention to the court challenge to the recent legislation. That’s going to determine whether this law is going to move forward in the structure in which it currently exists.

There’s another near-term item to watch as well. The Puerto Rico Electric Power Authority (PREPA) recently got a forbearance agreement that extends its letters of credit through August 14, while it continues discussions with various bondholders and lenders. Standard & Poor’s recent downgrade cited potential problems renewing those lines of credit, which it needs to purchase the oil it needs to run its plants.

Investors also should watch the upcoming TRANs issuance and PRIFA very carefully. If there is a market for them, that’s a positive; it gives the government some breathing room. If they can’t find buyers, it will definitely tell us that liquidity is going to be a problem. The recent formation of a group of hedge funds supporting the island’s restructuring plans may prove problematic for investors who own bonds from any of the entities subject to the Recovery Act. According to Bloomberg the group consists of about 18 hedge funds that hold at least $3 billion of Puerto Rico debt, most of which reportedly is exempt from the Recovery Act, and have combined assets of $60 billion. They could provide the Commonwealth with needed breathing room, but at a cost.

This is going to be a volatile and speculative situation. To put things into perspective, as of July 18, Puerto Rico’s probability of default was higher than that of Argentina or Ukraine, according to the market’s pricing of risk. On July 30, S&P declared that Argentina had technically defaulted. If an investor wants to get involved in this market, it will take a lot of homework to really understand what’s going on.

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The information presented above reflects the opinions of Thomas DeMarco and Ilya Perlovsky as of August 1, 2014. These opinions do not necessarily represent the views of Fidelity or any other person in the Fidelity organization and are subject to change at any time based on market or other conditions. Fidelity disclaims any responsibility to update such views. These views may not be relied on as investment advice and, because investment decisions for a Fidelity fund are based on numerous factors, may not be relied on as an indication of trading intent on behalf of any Fidelity fund.

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In general the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.)  Fixed income securities also carry inflation risk, liquidity risk, call risk and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so avoiding losses caused by price volatility by holding them until maturity is not possible.

High yield/non-investment grade bonds involve greater price volatility and risk of default than investment grade bonds.

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The municipal market can be affected by adverse tax, legislative, or political changes, and by the financial condition of the issuers of municipal securities. Interest income generated by municipal bonds is generally expected to be exempt from federal income taxes and, if the bonds are held by an investor resident in the state of issuance, from state and local income taxes. Such interest income may be subject to federal and/or state alternative minimum taxes. Investing in municipal bonds for the purpose of generating tax-exempt income may not be appropriate for investors in all tax brackets. Generally, tax-exempt municipal securities are not appropriate holdings for tax-advantaged accounts such as IRAs and 401(k)s.
Moody’s is an independent organization that assigns credit ratings to debt instruments and securities to help investors assess credit risk.
The GBD Economic Activity Index. The index is monthly report features a commentary on the Government Development Bank’s Economic Activity Index (GDB-EAI), a coincident index for the economy of Puerto Rico. The GDB-EAI is a valuable tool that summarizes the behavior of four major monthly economic indicators. Up to March 2012, these indicators were: total payroll employment, cement sales, gasoline consumption, and electric power consumption. As of April 2012, the electric power consumption variable was replaced by the electric power generation variable as the fourth indicator. Source: Economic Activity Index (GDB-EAI), Government Development Bank for Puerto Rico.
The Bank of America/Merrill Lynch High-Yield Index is a market capitalization–weighted index of U.S. dollar–denominated below-investment-grade corporate debt publicly issued in the U.S. domestic market. Qualifying securities must have a below-investment-grade rating (based on an average of Moody’s, S&P, and Fitch) and an investment-grade-rated country of risk. In addition, qualifying securities must have at least one year remaining to final maturity, a fixed coupon schedule, and at least $100 million in outstanding face value. Defaulted securities are excluded.
The S&P Municipal Bond Puerto Rico Index is a broad, market value-weighted index that seeks to measure the performance of bonds issued within Puerto Rico.
The S&P Municipal Bond Index is a broad, market value-weighted index that seeks to measure the performance of the U.S. municipal bond market.
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