Like most panics, the hysteria over Puerto Rico's debt is generating enormous amounts of misinformation. Careful investors who do their homework are likely to find the best buying opportunity currently available in fixed income.
The following are just three examples of hyperbole, false comparisons and misinformation expounded by careless journalists and commentators in the din of this hysteria:
Puerto Rico and its agencies have $70 billion in debt outstanding, more than any US state.
The "and its agencies" is kind of important. Those agencies include the electric utility, the water and sewer authority, the port, the airport, the university and other similar fee-based service providers. Adding all of this debt together would be like adding the debt of a state's public utilities, airports, colleges, quasi-public agencies and other similar entities to the state's general obligation debt. The real number for Puerto Rico's tax supported debt is something closer to $45 billion. This is a little over $12,000 per capital.
Since the Commonwealth provides most of the services cities and towns provide, in addition to those generally provided at the state level, comparing Puerto Rico's debt to US states is misleading. Chicago and New York have tax-supported debt per capita that is greater than their respective states. In contrast, of Puerto Rico's $45 billion in tax supported debt, less than 10% is local. Puerto Rico's $12,000 of debt per capita doesn't look all that bad in comparison to per capita state and local debt borne by (A3 rated) Chicago's citizens. For more on this see articles here, here, here and here.
The last article appearing on Bloomberg includes the following quote:
In a Jan. 16 report, she showed that Chicago's debt load per person was the biggest among the 25 most-populous U.S. cities -- and almost twice that of Puerto Rico, the U.S. territory that is groaning under $70 billion of bonds.
But the last thing I intend to do here is spread incendiary comments about Chicago's finances. These are just more of the kind of incendiary financial journalism I am decrying, and which, incidentally, I occasionally benefit from as an investor.
The real point is that even ignoring Federal debt, discussed below, Puerto Rico's tax supported debt is not as excessive as the more uninformed journalists and commentators have been suggesting. But the comparison cannot be just to state and local debt.
Perhaps the most important, and most overlooked, feature of Puerto Rico's government finances is that residents do not pay US Federal income taxes. Instead, the Commonwealth collects income taxes at a maximum marginal rate of 33%. Puerto Rico's total government revenues, including these income tax collections, equal about $2,300 per capita. According to the website usgovernmentdebt.com this compares to $17,791 in revenues per capita collected from mainland US citizens by Federal, state and local levels of government. The average resident of Puerto Rico pays significantly lower taxes than the average US citizen.
A "Restructuring" Is Inevitable
A parade of financial "experts", many with virtually no experience in public finance, appear weekly on CNBC and Bloomberg, opining that a restructuring of Puerto Rico's debt is inevitable. If Puerto Rico were a private corporation in a competitive market, it might reach a point where its effort to increase revenues are actually self defeating. Puerto Rico is a sovereign government with taxing power. When it raises taxes it collects more revenue. It has raised taxes, and it is collecting more revenue. If Puerto Rico were a US city, particularly one whose governor appointed a bankruptcy lawyer rather than an experienced leader in city government as emergency manager, it might file for Chapter 9 bankruptcy. Puerto Rico is a territory that is not covered by Chapter 9. The Commonwealth's constitution unequivocally requires that its government raise the revenues necessary to pay its debt. There is no legal path to a "restructuring", and the "path of least resistance" for Puerto Rico's government officials is to fix the operating budget rather than to restructure the balance sheet.
The Rating Agencies' Downgrades Are Evidence of Credit Deterioration
Really? These are the same entities that rated subprime mortgage pools AAA; the same entities that rated the bond insurers AAA immediately before they became insolvent and now rate several bond insurers that are comfortably paying claims non-investment grade. Two years ago, when Puerto Rico was bleeding financially, with no evidence of a turn-around in the credit, all three of these agencies maintained investment grade ratings. Now that a new administration has been making tough decisions and has spent a year implementing meaningful and painful expense cuts and tax increases, these folks downgrade the credit? By the way, the bonds have been trading as if they had been downgraded for at least 6 months. The rating agencies are the last to know.
The Commonwealth Doesn't Have Market Access
Any panic increases the risk that an issuer could face a liquidity crisis, and the Commonwealth may well have been better off if it had chosen to issue bonds last year instead of waiting for market conditions to improve. However, the Commonwealth will very likely issue bonds within the next 30 days. The recent rating actions by Moody's, S&P and Fitch were almost certainly part of the issuance process, as municipal market issuers typically apply to the rating agencies as they bring each new issue. The Commonwealth is holding a call for investors on February 19, and it will likely provide some clarity on schedule during that call. Investors who prefer not to rely on journalists for their information can get more information on the Government Development Bank's website.
Puerto Rico Bonds Are No Longer in "the Index" so Funds have less Reason to Buy
Puerto Rico is no longer in Barclays' high grade municipal bond index (or any other high grade index). It is now in the high yield index. In fact, Puerto Rico credits now represent something over 20% of the high yield index. High yield municipal bond funds listed in the following article total something over $50 billion. Can the portfolio managers afford to be 20% short their index? Just a few of these funds could provide enough buying power to buy all of the Commonwealth's upcoming general obligation bond issue, which is expected to be between $2 billion and $3.5 billion.
Puerto Rico has long had a troubling structural budget imbalance. The panic in the municipal bond market over its credit certainly increases the risk of a liquidity event. But at prices as low as 60 to 70 cents on the dollar and yields as high as 10% to 20%, for some credits and maturities, the hysteria is ridiculously overblown. Some Puerto Rico bonds are trading cheaper than Venezula's debt. Most importantly, for the first time in many years, the government is squarely addressing the fiscal problems. Those who are saying "too little, too late" don't understand government finance.
The upcoming bond issue represents an exceptional opportunity, and I suspect it will be heavily oversubscribed. I also suspect that the subscription of the new issue is likely to result in an immediate "relief rally", with fairly steep increases in prices for the new bonds and for bonds already trading in the secondary. Individual investors may have a tough time getting access to the new issue, as there is a long line of institutions who want or may even need to buy. Meanwhile, the secondary market still presents interesting opportunities, as investors can still find bonds yielding double digits. These opportunities will likely fade once the upcoming financing gets done and liquidity concerns abate.
Additional disclosure: I am long Puerto Rico GO bonds, University of Puerto Rico bonds, and Puerto Rico Aqueduct and Sewer Authority bonds.