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Puerto Rico - Third Quarter 2018 Review

by: David Kotok
David Kotok
Chief Investment Officer, Wealth Preservation, portfolio strategy

By Shaun Burgess

As the third quarter comes to a close, a fragile sense of optimism for the future of the Commonwealth of Puerto Rico has blossomed. It has arisen not just from the resolve of its people in the wake of Hurricane Maria but also from important milestones that have been reached in the long restructuring of Puerto Rico's debt, starting with the Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA). Economic conditions are beginning to improve.

We now sit a year removed from one the worst natural disasters in the Commonwealth's history, Hurricane Maria. The monumental storm shattered the lives of the citizens of Puerto Rico, causing billions of dollars in damages and contributing to the deaths of thousands. Today, the people of Puerto Rico remain entrenched in the long, arduous process of recovery and rebuilding. Billions of dollars are set to flow to the Commonwealth, but only a fraction of those funds has been received to date. Eventually, infrastructure will be rebuilt, quick patches will be replaced by permanent fixes, and time will help to heal those who have lost loved ones or their homes or livelihoods.

On the restructuring front, we have seen a number of important developments. These include restructuring proposals for the Puerto Rico Sales Tax Financing Corporation (COFINA) and the Puerto Rico Electric Power Authority (PREPA), as well as the continuing Title IV restructuring of the Government Development Bank (GDB) and ongoing negotiations for the possible Title IV restructuring of the Puerto Rico Aqueduct and Sewer Authority (PRASA).

One of the most important milestones to date remains the formal agreement among the Federal Oversight Management Board (FOMB), the government of Puerto Rico, and both senior and junior creditors, as well as monoline insurers, to restructure COFINA's existing debt. The restructuring of COFINA, at a massive $17.6 billion, would rank among the largest in municipal history. As part of the arrangement, COFINA bondholders have agreed to give up a portion of sales tax revenues to the Commonwealth: 53.65% of the pledged sales tax base amount on a "first dollar" basis would back new COFINA securities, while 46.35% would flow through to the Commonwealth. The disclosed terms would see existing bondholders receive new senior lien bonds secured by a 5.5% sales-and-use tax (SUT), with recoveries of 93% for senior bondholders and 56% for subordinate bondholders. Now, supporting the agreement are prominent general obligation bondholders Aurelius Capital Management and Six PRC Investments LLC. Although the support of such significant players is a welcome sign, it by no means signifies a "done deal." Unknowns remain, including the treatment of interest payments held in escrow for senior and subordinate bondholders.

The restructuring of PREPA represents another important milestone for Puerto Rico. Under the terms, creditors would receive two series of bonds. The first tranche will provide a recovery of 67.5%, and the second tranche will be a "hope" note at a recovery rate of 10%. Combined, this would be a total recovery of 77.5%, assuming full payment of the "hope" note. The terms have not been enticing enough to bring monoline insurers on board, so we wait for further developments.

In addition to the restructuring proposals for COFINA and PREPA, the restructuring of the GDB continues to move forward. The GDB announced on September 24 that it had received enough votes from creditors to move forward with the territory's only Title IV restructuring to date. This would cover some $4.2 billion in debt.

These events represent important steps forward for the Commonwealth. Coupled with improving economic conditions, they lead me to the optimism I alluded to in my opening. We urge caution, though, as execution risks remain high. There are no certainties until the plans have been finalized and Judge Swain has given them her blessing.

In the wake of recent developments, uninsured debt has risen dramatically from depressed absolute levels. We consider the movements speculative, as significant risks and hurdles remain. Insured debt has risen as well in response to the positive developments. We continue to favor carefully selected insured debt and believe it can offer an attractive value for clients.