About the expert
By any account, 2013 has been a bad year for Puerto Rico's municipal bond market. The S&P Municipal Bond Puerto Rico Index plunged more than 15% this year through November. By comparison, the S&P Municipal Bond Index is down just more than 2% during the same period. The poor performance in the bond market comes amid continued weakness in Puerto Rico's economy, public finances, and debt.
Several factors contributed to Puerto Rico’s municipal bond performance over the last 12 months. Puerto Rico’s credit ratings were downgraded to the lowest investment-grade ratings—Baa3 (Moody’s) and BBB- (Standard & Poor’s)—in late 2012 and early 2013. Then in November 2013, Fitch Ratings placed the Commonwealth on Rate Watch Negative. In addition, comments this spring from Ben Bernanke, chairman of the Federal Reserve, suggested that the central bank might taper its quantitative easing efforts later this year, which caused market interest rates to rapidly rise. Finally, the Commonwealth's economic difficulties have received considerable press coverage, including an August cover story in Barron’s comparing Puerto Rico’s financial troubles to the high-profile issues faced by Detroit. (Detroit’s July bankruptcy filing already had worsened sentiment toward weaker municipal credit.)
These events have sparked large outflows from municipal bond funds, which weakened liquidity in the municipal bond market and hurt the value of Puerto Rico debt. Institutional investors beginning in late August sold large blocks of Puerto Rico bonds, contributing to a roughly 10% decline in the S&P Municipal Bond Puerto Rico Index during the same timeframe.
Still, these bonds hold particular appeal for certain investors, because the interest on most Puerto Rico bonds is exempt from taxation at the federal, state and local levels. The triple tax-exempt status of Puerto Rico bonds makes them attractive to a diverse set of municipal bond investors, including many mutual funds. Morningstar estimates that three-quarters of all municipal bond mutual funds hold some Puerto Rico bonds.
Continued economic weakness
The Puerto Rico economy has been very weak since 2005. According to the World Bank, the island’s gross domestic product (GDP) declined for seven consecutive years through 2011, and posted meager 0.52% growth in 2012.
While the global economic downturn affected the Commonwealth, the main sources of its problems have been internal. Puerto Rico faces a range of economic headwinds, including weak demographics, a high cost of living, government employment representing more than 20% of the workforce, employment declines in the key manufacturing sector, inefficient and expensive public services, and a heavy public debt burden.
Puerto Rico’s economic weakness appears likely to continue. The Government Development Bank for Puerto Rico (GDB) publishes a monthly Economic Activity Index, which is highly correlated to its real gross national product. The index’s most recent average value for the 2014 fiscal year is 5.2% lower than the corresponding figure for the previous fiscal year.2
Puerto Rico’s government finances may be in worse shape than its economy. The Commonwealth has run a deficit in its governmental funds in each of the past 10 years. While the government has managed to shrink the deficit in its main operating fund from $3.6 billion in 2009 to a projected $820 million this year, it has done so by raising taxes, reducing employment and cutting public employee benefits. Historically, cutting deficits through measures such as these have dampened short-term economic growth.
The government’s large and persistent deficits have led to frequent borrowing and have compromised the Commonwealth’s ability to set aside adequate funding for its pension system. The pension system was only 8% funded on June 30, 2012, and its unfunded liabilities totaled more than 230% of the Commonwealth’s revenues—up from 124% in 2007.
The new administration in Puerto Rico has enacted meaningful and comprehensive pension reform. Consider the reform plan for its main pension fund, the Employees Retirement System (ERS), which is intended to provide cash sufficiency through reduced benefits and increased contributions. New reforms freeze ERS’s current defined benefit plans and move all participants to a new hybrid plan, where future benefits depend solely on employees’ contributions plus a return on investment. While these and other pension reforms are necessary and positive, they do relatively little in the intermediate term to reduce the large unfunded liability, because assets are not expected to begin to accumulate for another 25 years under the plan.
In terms of the Commonwealth’s cash position, the government has expressed confidence in its liquidity through at least June 2014, assisted by the private placement of about $1.2 billion of intra-year cash flow notes as well as an expanded sales tax pledge for additional sales-tax based bonds. Standard & Poor’s in October agreed with the government’s view on its cash position.
Puerto Rico's central government has relied on two primary tools—deficit financing and debt service restructuring—to bridge the structural imbalance between revenues and spending from one year to the next.
The government has taken many steps this year to reduce its budget deficit and its reliance on debt service restructuring. In addition to the pension reforms discussed above, the Commonwealth has increased revenues by broadening the tax base and managed its spending by reducing payroll. The Commonwealth estimates that the new tax measures may raise more than $1 billion, though it’s too early to gauge whether this estimate is accurate.
The Commonwealth also has taken significant steps toward making its main public enterprises capable of operating without budgetary subsidies or deficit financing. For example, Gov. Alejandro Garcia Padilla recently announced reforms aimed at the Puerto Rico Electric Power Authority. The reforms include the creation of a regulatory board, rate reductions of as much as 20% from their levels when the Governor took office, and a plan for cutting energy costs by 50% in 12 years. High energy costs have been a drag on the economy, with electricity rates per kilowatt hour nearly three times the mainland U.S. average.
Digging into the debt and insurance
The Commonwealth’s gross public debt was roughly $70 billion at the end of June. In 2012 this debt reached 112% of personal income, up from approximately 66% in 2003. Some $49 billion—or 70%—of the gross public debt was attributed to public enterprises, most of which is self-supported through dedicated revenue sources.
Certain public enterprises may be rated higher than the Commonwealth depending on insurance, the linkage to the Commonwealth or if there is a dedicated source of revenue outside the Commonwealth’s General Fund. The Puerto Rico Sales Tax Financing Corporation (COFINA) sales tax bonds are one such example. The senior lien bonds are rated A2/AA-/AA and reflect strong bond security provisions that include the first right to certain sales taxes collected in the Commonwealth of Puerto Rico, a collection mechanism that separates those monies from the General Fund, a non-impairment covenant by the commonwealth and an effectively closed senior lien.
According to Bloomberg data, the Commonwealth’s sales tax bonds have historically been the most actively traded Puerto Rico bonds and have been one of the top-10 trading names in the overall municipal market during October.
|G.O. Related Debt|
|Puerto Rico (PR) Commonwealth Full Faith and Credit Bonds:||$10,599 M|
|PR Guaranteed debt:||$5,634 M|
|Appropriation Debt:||$4,043 M|
|Sources: Commonwealth of Puerto Rico FY 2014 1Q Investor Webcast; FCM calculations. M = Millions|
|Sales and Use Tax (COFINA):||$15,224 M|
|Public Corporations/Agencies (PREPA, GDB, PRASA, HTA, Etc):||$25,575 M|
|Limited Obligations/Non-recourse:||$5,086 M|
|Local Municipal Debt:||$3,882 M|
|Sources: Commonwealth of Puerto Rico FY 2014 1Q Investor Webcast; FCM calculations. M = millions.|
We estimate that roughly 24% of bonds issued by Puerto Rico entities are supported with a financial guaranty insurance policy. Such policies guarantee timely principal and interest payments in the event of nonpayment by the bond issuer. The insurance companies providing these guarantees lost their AAA ratings during the financial crisis, but most of them may remain capable of paying claims in full when due.
On October 14, in relation to questions on Puerto Rico and Detroit exposures, Standard & Poor’s stated its capital-adequacy analysis of Assured Guaranty and National Public Finance Guarantee shows capital “very strong,” with sufficient cushion for higher potential losses due to “rating migration” and actual losses through 2015. Standard & Poor’s noted that while bond insurer aggregate exposure to Puerto Rico and Detroit may be “large” compared with current statutory capital, any claim payments would be made based on a payment schedule of the underlying issue with no acceleration, which allows insurers to manage liquidity and benefit from additional claims-paying resources. Furthermore, the Bond Buyer reported on October 25 that bond insurers have been and continue to ride a wave of municipal bond refinancings, which have bolstered their capital positions (the risk exposure on outstanding bonds is eliminated when an issuer refunds the bonds). Still, investors may not want to take the risk that an insurer fails to deliver on claims, and so they may want to look through the insurance to the individual issuer when making investment decisions.
Comparing rating agencies and the market's opinion
While Fitch has placed Puerto Rico's BBB- rating on Watch Negative, Moody's and S&P recently affirmed their Baa3/BBB- ratings, though both agencies continue to carry a negative outlook for the island’s government. Ratings are important because they may influence investor appetite for new debt, as well as the Commonwealth’s ability to issue it.
The Economic Activity Index, produced monthly by the GDB, may provide further guidance on how the Puerto Rico economy—and by extension the government’s finances—are likely to progress during the remainder of the fiscal year. Estimated revenue figures provided by the GDB monthly, as well as the fiscal 2015 budget proposal, could be key triggering events for the ratings agencies. Investors may be interested to note that market-implied ratings recently have suggested that the ratings agencies are well behind the curve.
The table below compares Moody’s MIRs, based on credit default swaps (CDs), with the current senior ratings for the Commonwealth’s general obligation bonds as well as select international sovereigns. The eight-notch differential between Puerto Rico’s market-implied and actual rating is particularly striking. In our experience, the actual rating may be suspect when the gap between these two measures is larger than three notches. That said, an MIR equivalent to Venezuela or Jamaica may be excessively pessimistic. But any downgrade below investment grade may result in some forced selling of Puerto Rico credits and increase volatility in the municipal market overall—especially in lower-rated credits that share some of the same characteristics as Puerto Rico.
|Moody's Market Implied Ratings|
|Sovereign||Moody's Market Implied Rating||Actual Senior Rating|
|Source: Moody’s ‘Puerto Rican Market Signals on Down Slope. 10/28/13.|
Market Implied Ratings translate prices from the CDS, bond and equity markets into the standard Moody’s ratings scale. Market Implied Ratings are available on both an issuer-lever and security-level basis. An implied rating is calculated by comparing an entity or security’s trading price to the trading prices of all other entities or securities in the same Moody’s rating category. Market Implied Ratings are not the actual long term ratings assigned by Moody's.