Puerto Rico is expected to issue $2 – $3.5 billion in general obligation (GO) bonds later this month, the latest since a $2.7 billion offering in 2012, and with all the attention on the island’s credit rating over the last six months both traditional muni investors and new investors are expressing interest in the GO bonds.
“The Commonwealth of Puerto Rico’s fiscal problems have transfixed market participants, not only in the municipal world, but across the fixed income landscape and investors struggling with a low yield and a low supply environment face the quintessential risk vs. reward dilemma while evaluating Puerto Rico (PR) debt,” write Citi analysts Vikram Rai, Mikhail Foux, and George Friedlander, offering up a full SWOT analysis of the upcoming deal.
Puerto Rico’s Strengths and weaknesses
One of the main strengths of the upcoming GO issuance is that the current administration in Puerto Rico has made it clear that it takes external market concerns seriously. One example is the current GO offering itself, which is partially being held to assuage liquidity fears even though the island probably doesn’t need additional financing until 2015. Additionally, Puerto Rico has agreed to waive its sovereign immunity and give New York state courts jurisdiction over the bond issuance, showing a firm commitment to repaying its debts.The administration is also working to balance the territory’s budget by 2015, which most analysts believe it will manage to do if its pension reform efforts survive court challenges.
The Citi report also points out that while the muni bond market can sometimes be fragmented, making holdings somewhat illiquid, there is enough trade volume that this shouldn’t be a problem for Puerto Rican bonds.
The deal’s main weakness is the state of the Puerto Rican economy, which has been in recession since 2006 and still has abysmal unemployment: 15.4% with a 40% labor force participation rate. The Puerto Rico Planning Board forecasts another 0.8% GNP contraction in 2014 and the island’s population continues to decline.
Years of deficit spending are also hampering the government’s ability to implement new policy since 20% or more of revenues will have to go toward debt servicing and pensions for the next decade. There have been some op-eds wondering why the US Federal government won’t backstop Puerto Rico’s debt when it has bailed out entire industries, but there most analysts including those at Citi don’t expect this to happen if Puerto Rico defaults on its debt.
Opportunities and threats
Right now the Purto Rican GO curve is inverted, which means that investors are worried about a credit event in the near future, but expect Puerto Rico to recover as long as it can navigate this short-term danger. Assuming the GO issuance goes as planned, this curve should flatten and could even flip, providing the opportunity for investors to get a boost.
The most obvious threat to investing in Puerto Rican GOs is essentially the opposite of that opportunity – the US territory has enough liquidity to last through 2014, but it could start to have problems in 2015 if it doesn’t raise funds. Since this is exactly what the GO issuance is meant to solve and investors seem ready to participate, the odds of a near-term liquidity crisis should be low. Additionally, Puerto Rico has more than five thousand pending cases against it on a variety of fronts that could cost as much as $2.7 billion in unfavorable judgments. A wave of lost cases could undo a lot of the financing that Puerto Rico gets from GOs this month.