Puerto Rico Bondholders Must Be Treated Fairly

by: Financial Freedom Institute
Summary

The Puerto Rico bond situation will take a long time to resolve.

There is some risk of a GM/Chrysler cramdown but the odds are more in favor of a fair resolution.

There is a lot riding on this for Judge Swain, who knows it could set a precedent that gives every single municipality a reason to cramdown bondholders.

The worst case auto bailout situation of 29 cents on the dollar is extremely unlikely. 70 cents is more likely.

There is opportunity for a variety of bonds and a variety of investors. A few examples are provided.

The situation regarding Puerto Rico's bonds is far from over, and will likely to take years before the matter is fully resolved. However, there is a central issue for investors, and all investors should be vocal about it: bondholders must be treated fairly.

If bondholders are crammed down in this seminal bankruptcy proceeding, then not only will investors be left holding the bag, it will set a dangerous precedent going forward.

Puerto Rico's situation is unique. This article will discuss 1) best and worst case scenarios for some bonds, 2) the many steps still available for bondholders (and investors) to ensure they get maximum payout of their obligations, 3) an overview of opportunity and risk in some of the many bonds, and 4) why the outcome is so important to the muni market going forward.

Worst Case: The Auto Bailout Analogy

Puerto Rico is a highly unusual situation, and in some ways parallels the General Motors and Chrysler bailouts during the financial crisis.

For the first time in American bankruptcy history, the legal concept of absolute priority was ruptured. Instead, the United Auto Workers union - which was an unsecured creditor - received 40 cents on the dollar and the secured bondholders got only 29 cents on the dollar. The bondholders were also robbed of their deficiency claim. That's because both the GM and Chrysler bankruptcies were jammed through under Section 363 of the Bankruptcy Code. The federal government gutted the rights of secured bondholders, by breaking long-established statutes and principles regarding bankruptcy. Political forces strong-armed the creditors.

By the end, the government owned 55% of the new GM, and 8% of the new Chrysler. The UAW owned 55% of Chrysler and 17% of GM. Thus, the government and a union with enormous political influence now effectively controlled both manufacturers - instead of by the bondholders, who should have control, based on all of American history.

That's the benchmark for the worst-case scenario: in which a government and political entities crammed down bondholders to 29 cents on the dollar.

However, this likely represents a floor for secured bondholders. That situation was the result of a major American crisis, and the solution was wildly egregious.

Best Case: Bondholders Treated Fairly

There are many similarities, but also key differences, with Puerto Rico. These differences include a greater likelihood that bondholders will recoup far more than 29 cents, because many of the worst tactics in the auto bailout are not in play.

This gives bondholders and investors opportunity to be treated fairly.

In June of last year, Congress passed the Puerto Rico Oversight, Management, and Economic Stability Act - known as PROMESA (the Spanish word for "promise"). The legislation created an Oversight Board ("OB").

One of the reasons Puerto Rico bonds are getting hit is because several elements of PROMESA parallel the auto bailout. A key element of the OB is that it supercedes Puerto Rico's constitutional powers - effectively handing fiscal control of the Commonwealth over to the OB's seven individuals.

Sec. 101 of PROMESA has some concerning elements at first glance:

1) Only the Oversight Board (and not the creditor) may file a plan of adjustment of debts of the debtor.

2) Creditors may not file competing plans.

3) The OB does not have fiduciary responsibility, i.e. it is not required to act in the Commonwealth's best interests.

4) The OB's members have the power to override Puerto Rico's laws, as well as the powers of elected officials.

5) The OB has no liability for their actions.

This suggests the bonds could be headed for the worst-case scenario -- but this doesn't tell the whole story. A boatload of activity is rightly putting pressure on the OB to do what it should - get back to negotiating with creditors.

First, there are a bevy of lawsuits by the COFINA bondholders (sales-tax-backed debt) challenging the constitutionality of the bankruptcy process. One lawsuit by COFINA holders says that the OB is trying to repurpose tax revenues to push them lower in the capital stack, and that violates Due Process and the Takings clauses.

Bond insurer Ambac Financial Group (AMBCW) is suing the Puerto Rican government, as well as the OB, to stop the PROMESA bankruptcy and force a fiscal blueprint that helps the Commonwealth resolve the long-term fiscal issues. That also puts bondholders in the catbird seat, as they should be. Meanwhile, National Public Guarantee Corporation has a lawsuit that tries to force negotiations with creditors.

Second, bondholders have significant PROMESA language on their side. Section 314(b)(6) says that any bankruptcy plan has to be approved if it "is feasible and in the best interests of creditors, which shall require the court to consider whether available remedies under the non-bankruptcy laws and constitution of the territory would result in a greater recovery for the creditors than is provided by such plan."

This trumps the more unfair elements of PROMESA's other clauses, and that means the judge in the case has to meet these standards. So while Puerto Rico may have rushed into bankruptcy to escape the situation, it is merely a delay. The judge can also look to any part of the law to ensure fairness.

And she will.

Indeed, there's a great deal of optimism in that the debt restructuring is going to be overseen by Judge Laura Swain. Swain has proven to be thoughtful and particular - such as not immediately accepting a plea in the SAC Capital case, and instead researching the entire case for several months.

Swain must take 314(b)(6) seriously and conservatively, and use all the law at her disposal to get the parties to come to a rational agreement. That's only fair, of course. Why should bondholders and insurers have to bear the burden without such negotiations?

Swain has additional reason to be exceedingly fair to bondholders. All eyes are on this case. If bondholders are not treated fairly, if they are crammed down unreasonably, if bond insurers have to pay too much for the defaulted bonds, or if Puerto Rico escapes this crisis without bearing a reasonable burden for its own demise, Swain's entire reputation and career will be irrevocably damaged.

That's because it will open the door for all municipalities, including the states, to default on their obligations, with Swain having set a precedent that absolves them of pain.

Not being fair to bondholders will make borrowing more expensive for all municipalities, as the day will come when one of the states will default. Debt capital will suddenly have higher risks that ever before. Muni bonds of all stripes could sell off, as the perceived safety of double tax-free income suddenly won't be so safe.

Third, the OB is also getting pressure from journalists insisting on transparency. The Puerto Rico Center for Investigative Journalism ("CPI"), sued the OB, alleging it has "ignored multiple requests to share information tied to the commonwealth's fiscal standing, as well as financial disclosures and conflict of interest forms submitted by all seven members of the oversight board to the White House and the US Treasury Department."

PROMESA Section 101(c) states the OB "shall be created as an entity within the territorial government" and "shall not be considered to be a department, agency, establishment, or instrumentality of the federal government." Furthermore, because the Puerto Rico Supreme Court has ruled in the vein of almost every state court on matters of open records access as being essential to democracy and public policy, there is no reason to believe that PROMESA somehow invalidates that principle.

The lawsuit is damning, alleging that the OB is required to turn over documents akin to those that must be made available under an FOIA request. The CPI won a similar lawsuit last year, and there is precedent established in that case. This will force the OB to be transparent in its process, and reduce the possibility of a bondholder cramdown.

Fourth, Prof. David Skeel is on the OB. Skeel excoriated the auto bailout for the very reason that it violated the rule of law. bondholders were illegally crammed down. Now he has a chance to make certain that doesn't happen. If he does, he's going to damage his reputation as well.

Finally, the final offer made to bondholders prior to declaring bankruptcy was for 70 cents on the dollar. So there is also a decent chance that bondholders will get even more during a fair negotiation.

Opportunities for Investors

(All data from MunicipalBonds.com)

Given the notorious auto bailout scenario, downside risk for secured issues trading in the 30's and low 40's seem limited. Secured bondholders in the auto bailouts were bullied by the federal government to take 29 cents on the dollar. Yet the situation here is very different. Likewise, the aforementioned 70 cents on the dollar, which was offered, would seem to be a minimum that bondholders receive. The COFINA bonds are of primary interest, as there are lawsuits regarding how high in the capital stack they are. The market appears to be discounting the possibility that they will be pushed lower in the stack. Thus, the Puerto Rico Sales Tax Financing Series C (COFINA) (CUSIP:74529JNN1) bonds are trading at 54, based on their offering price of 114.638. There may be opportunity here in particular, as much as 30% if one believes the seventy-cents-on-the-dollar offer represents a floor of some kind. Obviously, subordinated issues are getting hammered the most. For example, Puerto Rico Sales Tax Financing Capital Appreciation First Subordinated Series C (CUSIP: 74529JLR4) are zero-coupon bonds issued at 15.02, but which last traded for 5.693. Puerto Rico Commonwealth Highway And Transportation Authority Transportation Revenue Subordinated (CUSIP:745190MS4) were issued at 98, had a 5% coupon, but now trade at 6.125. Meanwhile, other uninsured bonds like Puerto Rico Commonwealth Government Development Taxable Senior Notes Series A (CUSIP: 745177FM2) are trading at 34.25, as are the Series C, Series H, Puerto Rico Commonwealth Government Development Senior Notes Series B Build America Bds (CUSIP: 745177EP6), with the Series I having recent trades at 34.82. A number of other issues are trading around 40, or in the low 40's. Several mature at 100, while others mature in the low-to-mid 90's. There is a lot of risk in issues like these uninsured subordinated bonds. They are probably low enough in the capital stack that bondholders may get nothing. On the other hand, the pricing is so low that aggressive speculators may see substantial upside as the story unfolds - and one never knows how things will unfold.

The list of all Puerto Rico bond offerings can be found at the MunicipalBonds.com link above. However, for those interested in the mutual funds, the links are below. Because of the diversification, none of these have more than 4.6% exposure to any Puerto Rico bonds. Thus, while a few have sold off, they never fell by more than 6%.

Franklin Templeton Funds with Puerto Rico exposure.

Oppenheimer Funds with Puerto Rico exposure.

However, for now, investors may want to stay away from any of the bonds issued by states of the Mercatus Center's list of states that are in fiscal trouble. The list is far too exhaustive to provide here, but there's simply no reason to get involved in something like the Franklin California Tax-Free Income Fund (MUTF:FKTFX). Look at the list of holdings and the extensive list of state-issued debt. Should the bondholders get crammed down, these are the funds and bonds that will get crushed. Indeed, here's a fine SA article on why you should avoid Illinois and New Jersey.

Going forward, the attractiveness of muni bond funds with mid-single-digit tax-free yields should be scrutinized carefully. If a Puerto Rico cramdown occurs, all bets on all states in fiscal trouble will be off.

Why get caught? Why take the risk? There are plenty of preferred stocks yielding the same or more out there, and many yield 8-9%. After taxes, the yield is still competitive with far riskier muni bond funds.

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.