- Puerto Rico's fiscal condition has been compared to Greece's.
- This ignores Puerto Rico's credit strengths including debt service under 15% of government revenues.
- But what is most misunderstood about all governments' finances is that lack of will, not lack of means, is usually the more serious threat to bondholders.
Puerto Rico's financial condition has often been compared to Greece's. The comparison is not particularly informative and ignores important differences. For example, Greece's debt per GDP was nearly 2x Puerto Rico's at its height. Puerto Rico also has a very manageable debt repayment schedule with annual general obligation (GO) debt service limited by its constitution to less than 15% of government revenues. Viewed through this lens, defaulting on its debt seems hardly worth the distraction. Puerto Rico's constitution also provides strong protection to GO bondholders, including a prior claim on all government revenues, including tax revenues pledged to other credits. Importantly, this "clawback" provision does not apply to revenues of independent agencies such as the Puerto Rico Electric Power Authority or the Puerto Rico Aqueduct and Sewer Authority, which charge fees for service.
To be sure, investors need to understand the credits they are buying, as (for example) some credits such as the Highway bonds are effectively subordinated to the GOs. However, in the end I believe all of Puerto Rico's bonds will be repaid with interest, a view I have held since the "crisis" began (see previous articles here and here).
However, commentators who insist on comparing Puerto Rico to Greece should consider recent developments on the other side of Greece's fiscal crisis. A recent Bloomberg article describes the round trip for Greece's lenders and the table below from the article provides a useful summary.
My point is not to suggest that the recovery in Puerto Rico bond prices will be as swift or steep as Greece's. It is to highlight a feature of government debt that is largely misunderstood: The revenues stream available to holders of government bonds is far more robust than most observers appreciate. Taxing power and monopolistic enterprises are extraordinarily resilient credits that can recover from extremes of mismanagement.
Despite the long term strength of government revenue streams, governments are often slow to respond to fiscal challenges, and few governments maintain the level of cash reserves, relative to the size of their operations, that a private company would. As a result, lack of near term liquidity is often more of an issue than long term insolvency. While illiquidity can be frightening to analysts at credit rating agencies and investors (particularly short term investors), the experience of investors in downgraded or even defaulted bonds of New York City, Cleveland, Bridgeport, Massachusetts, Orange County, Philadelphia, District of Columbia, California and numerous other credits demonstrates how resilient government finances can be, if the political will exists to address the challenges.
It is now historical fact that Detroit's debt was unsustainable, but is it possible that the difference between Detroit and the examples of fiscal stress listed in the previous paragraph is political will and not fiscal condition or means? When the governor of Michigan appointed a bankruptcy lawyer as Detroit's Emergency Manager, it seems like bankruptcy was inevitable. Whether Detroit's operations are reformed in a meaningful way remains to be seen. Repudiating debt certainly seems like a path of less resistance, at least for a skilled professional with significant experience with the bankruptcy process.
If a clear path to bankruptcy existed for Puerto Rico's leadership to follow, it is conceivable that this path of less resistance would be considered. There is some noise about legislators proposing such a path, but such legislation does not seem to be supported by the executive branch and in any case, it would likely face significant legal challenges. Perhaps more importantly, the current Administration has been unwavering in its commitment not just to the statutory and constitutional obligation to repay its debts, but to the moral obligation. This commitment seems to have received scant attention in the financial press and insufficient consideration by rating agencies. I suspect its value will be more appreciated by investors over time: political will matters.
Additional disclosure: I am long bonds of the Commonwealth of Puerto Rico, Puerto Rico Aqueduct and Sewer Authority and the University of Puerto Rico.