Puerto Rico Bonds Can Be A Solid Investment

by: Richard S. Daskin CFA, CFP(R)
Summary

Certain Puerto Rico debt is undervalued.

Credit selection is critical.

The ratings don't accurately account for the risk of loss; the rating agencies assess probability but not severity.

Many commentators have never cracked an official statement to properly understand the risks.

Puerto Rico is NOT Greece.

Below are excerpts from a white paper sent to my clients recently:

Puerto Rico is going through a necessary financial adjustment to better align the Commonwealth's costs and government with the island's economic resources. The story has been out there for a while, and the press has bled a lot of ink, with some valid points, but with many poor comparisons and scary headlines which are not necessarily accurate. It sells, though. Below are some of my thoughts on the subject, as well as the portfolio process I have used to invest money for clients in this market.

Puerto Rico has been in a recession or a no-growth economy since 2006. Part of this problem can be put down to poor governance, but most of it has to do with slow growth worldwide and a change in US tax law that made it less advantageous for manufacturers to locate their businesses in Puerto Rico. Thus, the island has to adjust its economic base and find new sources of economic growth and development. This is something the island has experienced before, and in the past, it has made adjustments as necessary.

The Commonwealth's overall debt level is on the high side. You may see comparisons in the press to other US states. This is a poor and unfair comparison to the island. Puerto Rico is not completely innocent here, either; it has used deficit financing too liberally, and probably needed to make adjustments to the size of its government sooner. However, there are some real flaws with some of the comparisons being made. First, unlike US states, Puerto Rico is a Commonwealth, and so takes on some of the functions of the US federal government. And in many cases, it is also responsible for the functions of local government. Puerto Rico citizens do not pay US federal income taxes, and thus, a fair comparison would not include US federal debt in the debt burden calculation for Puerto Rico, unlike mainland states. Comparisons also frequently cite the gross debt burden, including some of the its agency debt, such as the electric power authority (PREPA), highway authority (PR Highway), and water and sewer authority (PRASA). These authorities have been poorly run, but for the most part, they are self-supporting - or will be once PREPA has been restructured. If you factor in all of the above, the debt burden is on the high side, but nowhere near the same as, for example, another comparison being made in the press - Greece. And while I am on the subject of Greece, I should point out that on an after-tax basis uninsured Puerto Rico debt is trading about 3-5 percentage points cheaper than comparable Greek debt. In my view, this is a market anomaly and makes no sense. Greece is a serial defaulter historically, while Puerto Rico has never defaulted on its debt. The economy of Greece has contracted about 25% in the last several years; while in contrast, Puerto Rico has had a slow but painful contraction or no growth.

PREPA is a problem for the island, but not an insurmountable one. Their problems have been bandied about. There are many - to cite a few, collections are poor (including the fact that the Commonwealth and its instrumentalities owe the utility a substantial amount of late bills), rates are high, operations appear to be inefficient, and the sources of generation are focused on one type of fuel - oil-fired plants, which are expensive to run. Rates are also constantly cited - the press talks about rates being much higher than on the mainland. All I can say on that is, no kidding. Puerto Rico is an island without natural resources. It cannot plug into a grid, and must import its fuel requirements. A fair comparison is another Caribbean island, or Hawaii, perhaps. When you make that comparison, it is not nearly as dramatic. Also, Puerto Rico has not raised its base electric rates for 25 years. The bottom line is that these problems are all fixable, and in fact, PREPA will be restructured - the island has no choice in the matter.

Puerto Rico also needs to have a more efficient tax scheme and have better tax collections. That is the driving force behind recent legislation to switch from sales and income taxes to petroleum import taxes and a value-added tax. However, the government seems to have been ham-handed in its communications with the rating agencies and its bondholders. When the island sought to introduce a local bankruptcy statute for its agencies, it proceeded to destroy confidence in its Constitutional pledge to put debt service before other expenses on its GO debt.

Conclusion

Puerto Rico undoubtedly has challenges before it. But it has the resources and the ability to right the ship. The short-term problem is liquidity and financial management. The Commonwealth and its instrumentalities are short on cash. It is my view that the island can be and should be solvent if it makes correct adjustments and helps its economy to resume growth.

Well-secured insured paper in Puerto Rico is trading at levels well over investment-grade municipal credits, and offers investors an extra 200-300 basis points versus other investment-grade insured credits. For the more intrepid, the junior and senior secured bonds of Puerto Rico Sales Tax (COFINA) and Puerto Rico general obligation bonds offer yields that are cheaper than Greek debt, with much less risk of default. In the event that the bonds do default, the likelihood of bondholders taking much of a loss at these levels is low.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Clients of the author's firm may be long the securities mentioned in the article. Investors should carefully do their own due diligence prior to investing in any securities mentioned in this article including consulting ratings, and reading the official statements of any securities they may contemplate buying. Credit is often difficult to predict accurately and high yield investing has unique risks an investor should consider prior to making any investment. Prior to making any investment an investor should consider consulting an investment professional.