Last July, for the first time in 84 years, Puerto Rico has defaulted on its debt. It is the first time that any state (or U.S. territory) has defaulted specifically on general obligation bonds since the Great Depression. While the bond markets did not collapse as a result - mostly because the default was expected - if Puerto Rico fails to comprehensively restructure in a manner that is fair to all debtholders, there will be substantial risk to the muni bond market, and for Puerto Rico's economic development.
Puerto Rico's debt stands near $70 billion, and is spread across numerous portions of the public sector. GO bonds account for 17%, or almost $12 billion of that debt. Non-tax-supported public corporations account for about the same, and commonwealth taxes account for near a third.
As with any debt default, there was a flurry of activity over how to resolve the crisis. House Speaker Paul Ryan, at the behest of President Obama, had Congress create the Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA) shortly after Puerto Rico's default.
An Oversight Board was created, consisting of seven individuals from both sides of the aisle: Arthur Gonzalez (a former US Bankruptcy Judge who presided over the reorganizations of Enron and WorldCom); Jose Gonzalez (former CEO of Santander Bank's Puerto Rican subsidiary); Ana Matosantos (former director of California's Department of Finance); Carlos Garcia (CEO of a private equity firm and former COO of Santander, as well); Jose Carrion (a bankruptcy trustee); Andrew Biggs (from the AEI); and David Skeel (a professor of corporate law). The Board was supposed to create a new fiscal plan that aimed to spur economic growth and reduce spending.
Unfortunately, Governor Ricardo Rosselló, led the way in coming up with fig-leaf reforms and the Board rejected it. Like most municipalities and corporations that are tasked to right a default, initial proposals are fantastical in nature, relying (according to the Board)," on overly optimistic revenue and economic growth forecasts". Setting aside but $1.2 billion a year to service debt, and thus screwing over 70% of bondholders, is not the least bit realistic.
On March 11th, a new plan was delivered and mystifyingly approved by the Board, and it is a disaster for bondholders. All it speaks to is how to increase cash flow, and cut expense - which are fine - and aims to satisfy the GO bondholders, which is also good. However, all other creditors the rest are left out in the cold, having to absorb a 70% cram-down.
There is no way these other creditors will stand for this plan and as of May 1, they will have the ability to litigate.
Congress has a role to play. Because Puerto Rico is a U.S. Territory, Congress does have the authority to pressure the Oversight Board to rescind its approval, and put the process onto a different track - a comprehensive and cooperative restructuring plan.
PREPA - Another problem
The same oversight board is trying to cram through a deal with the Puerto Rico Electric Power Authority (PREPA). PREPA also has $9 billion debt obligations, but are not direct obligations of the Commonwealth of Puerto Rico.
Two years ago, when PREPA ran into fiscal trouble, a Restructuring Support Agreement was forged. Creditors were only forced to take a $972 million haircut, just under 11% overall. The reason for this relatively small slice as because the 2017-2020 fiscal plan relied on an estimate of $7 billion being available for debt service.
However, in the new plan that the Oversight Board approved, that cash flow has fallen dramatically - to $2.8 billion. That means a much larger haircut for creditors. It's a mistake to negotiate this debt separately. It should be included as part of a comprehensive restructuring of all debt obligations, that includes fiscal reforms.
There's wisdom in this approach because it may permit Puerto Rico to pull larger concessions specifically from PREPA creditors. That could also result in lower electricity costs for everyone, both consumers and businesses.
Specific issues were highlighted in a letter from private business organizations in Puerto Rico, sent to Rep. Doug LaMalfa, the Chairman of the House Resources Subcommittee on Indian, Insular, and Alaska Native Affairs:
"PREPA's Restructure Support Agreement is a punitive proposition for consumers and electricity ratepayers who will suffer higher rates under this agreement which preserves the government run PREPA monopoly while locking out private sector and alternative energy competition. Even bondholders who will see the Puerto Rico electrical system unravel as Puerto Rico ratepayers are unable to comply with such costly requirements. The end result of these high electricity costs will be an even weaker economy¨ greater population losses¨ and less new investment in job creation" (translated from Spanish)"
Why This Matters
Whether an individual, corporation, or municipality, capital markets always view defaults the same way. If creditors are made whole, or at least are treated fairly, the defaulting party will have an easier time in the future obtaining more capital, and at more favorable rates. If creditors get crammed-down, capital providers will look askance at the defaulting party for years to come.
Capital will become significantly harder to obtain, and when obtained, will come with higher interest rates. Even general investors will be reluctant to engage with the territory. All this does is severely curtail Puerto Rico's long-term economic growth, when the territory already suffers from a 45% poverty rate.
Puerto Rico deserves better, especially as a U.S. territory. There is simply no reason why a full and fair restructuring cannot occur. Indeed, both US law and the World Bank have legal and policy principles regarding "similarly situated creditors", and Puerto Rico is ignoring them.
As far as investing goes, an enormous amount of this defaulted debt rests in muni bond funds. The top 20 holders of Puerto Rican debt, by dollar amount and percent of assets, according to Morningstar are:
· Oppenheimer Rochester Fund Municipals (MUTF:RMUNX): $1,386,432,402
· Oppenheimer Rochester High Yield Municipal Fund (MUTF:ORNAX): $741,876,715
· Oppenheimer Rochester Ltd Term New York Muni Fd (MUTF:LTNYX): $712,381,191
· Franklin California Tax-Free Income Fund (MUTF:FKTFX): $661,658,064
· Oppenheimer Rochester Limited Term Municipal Fd (MUTF:OPITX): $597,408,828
· Franklin High Yield Tax-Free Income Fund (MUTF:FRHIX): $332,201,234
· Franklin Federal Tax-Free Income Fund (MUTF:FKTIX): $249,293,382
· Goldman Sachs High Yield Municipal Fund (MUTF:GHYIX): $235,846,845
· Oppenheimer Rochester AMT-Free Municipal Fund (MUTF:OPTAX): $225,043,988
· MainStay High Yield Municipal Bond Fund (MUTF:MMHIX): $215,681,932
· Franklin Double Tax-Free Income Fund (MUTF:FPRTX): 47.23%
· Oppenheimer Rochester Maryland Municipal Fund (MUTF:ORYCX): 36.42%
· Oppenheimer Rochester Virginia Municipal Fund (MUTF:ORVAX): 34.60%
· Oppenheimer Rochester Fund Municipals : 23.06%
· Oppenheimer Rochester Ltd Term New York Muni Fd : 20.93%
· Oppenheimer Rochester Limited Term Municipal Fd : 19.95%
· Oppenheimer Rochester Arizona Municipal Fund (MUTF:ORAZX): 19.86%
· Oppenheimer Rochester Michigan Municipal Fund (MUTF:ORMIX): 19.81%
· Oppenheimer Rochester North Carolina Muni Fund (MUTF:OPNCX): 18.70%
· Oppenheimer Rochester New Jersey Municipal Fund (MUTF:ONJAX): 18.29%
In addition, over 100 ETFs hold Puerto Rican debt of some kind, although thankfully none have them in anywhere near the concentration that mutual funds do. PowerShares KBW Regional Banking Portfolio ETF (NASDAQ:KBWR) has the largest weighting, at 1.83% of assets.
Finally, any time a large municipality defaults, it threatens the entire muni bond market. So far, catastrophic damage has been avoided. However, with Puerto Rico now the largest of its kind to default, other large municipalities and even states, will be watching to see what happens. Permitting politicians to draw up inadequate, short-sighted, and unfair plans adds additional long-term risk to an investment class that is supposed to be a source of less-risky income.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.