Puerto Rico’s Debt Crisis by Joseph Deane, David Hammer, Sean McCarthy, PIMCO
Puerto Rico’s municipal debt has been mired in negative news headlines and heightened price volatility. Joe Deane, head of municipal bond portfolio management, Dave Hammer, municipal portfolio manager, and Sean McCarthy, head of municipal credit research, recently discussed the evolving situation and how it affects PIMCO’s muni market outlook and portfolio positioning.
Q: Over two years ago, PIMCO implemented a 0% allocation to Puerto Rico’s municipal bonded debt across our dedicated municipal portfolios, a major statement given the amount of the island’s debt outstanding. What led to that decision?
Deane: We have long viewed the challenge facing Puerto Rico (PR) as a debt sustainability issue. This led us to sell the last position in PR debt in our dedicated municipal portfolios in the first quarter of 2013 at a premium dollar price. And today, firmwide, we maintain zero exposure to Puerto Rico credit risk. PIMCO’s rigorous top-down, bottom-up investment process confirmed our suspicions and informed our decision. Our credit research team’s analysis of PR’s capital structure has been extensive and exhaustive. When we weighed the economic, demographic, political and financial makeup of the island against the sheer amount of liabilities outstanding – $73 billion of bonded debt and around $30 billion of unfunded pension liabilities – it led us to conclude that the Commonwealth would face significant challenges making creditors whole on those obligations.
Q: Puerto Rico bond valuations set new lows toward the end of June. What drove this latest market move?
Hammer: Over the last year, market consensus was that general obligation (GO) debt was senior in the capital structure to other PR debt and liabilities, primarily due to a constitutionally protected claim on the Commonwealth’s available resources. This view was turned on its head at the end of June with the release of a report by Anne Krueger, a former deputy managing director at the IMF, and statements made by Puerto Rico Governor Alejandro García Padilla. Krueger’s report cites large and growing cash needs that our bottom-up credit-screening process identified long ago. The report and the governor’s comments signal the need for a “comprehensive solution” entailing broader debt relief that would affect most parts of the PR capital structure, including GO bonds.
Puerto Rico also revealed that it has hired Steven Rhodes, the former U.S. federal bankruptcy judge who presided over Detroit’s bankruptcy case, as a consultant. Rhodes has since told Reuters that “the parallels between Detroit and Puerto Rico are strong enough that I think any of the public corporations or the Commonwealth itself could take advantage of the same kind of process that we used in Detroit.” In Detroit, pensioners fared significantly better than GO bondholders; pensioners received 75 cents to 90 cents on the dollar, while GO holders received 20 cents to 75 cents. If Puerto Rico is restructured similarly, it implies recoveries much lower than those implied in bond trading levels currently.
GO bonds were down 7 to 8 points during the week following the release of Krueger’s report. The most liquid bond traded down to $65, a record low, before closing the week at around $69; it was issued at $93 in March 2014.
Q: What is the outlook for the Commonwealth?
McCarthy: The summer will be unusually busy for the island. The governor has established the “Working Group for the Economic Recovery of Puerto Rico,” which is expected to provide legislators with recommendations for economic reforms and fiscal adjustments by August 30. Among the group’s goals, according to Governor Padilla, is a negotiated agreement with bondholders to postpone the payment of debt for a number of years. An exhaustive education campaign will follow to sell the recommendations to politicians, creditors and citizens.
On July 13, Government Development Bank (GDB) President Melba Acosta and several of the island’s advisors, including Krueger, met with creditors. During the meeting, the advisors avoided questions about specific plans to restructure public debt. The island intends to negotiate its capital structure on a case-by-case basis with creditor committees over the next several months. In the meantime, uncertainty over how divergent interests affect outcomes and the ability of issuers to make timely debt service may exert further pressure on bond prices. The GDB, Sales Tax Financing Corporation (COFINA) and the Puerto Rico Public Finance Corporation (PFC) all have debt service payable in August. We expect the GDB must reprioritize some payments given its precarious cash position, and on July 15 the island failed to appropriate $94 million to a bondholder trustee ahead of PFC’s August 1 debt service payment. We are interested in observing whether Puerto Rico will appropriate sufficient funds on time to make the payment and, if not, whether the island will concurrently default on COFINA’s August 1 debt service payment.
The failure to pay any August 1 debt service may also serve to pressure the U.S. Congress to more seriously consider extending Chapter 9 of the U.S. Federal Bankruptcy Code to PR’s municipalities and public corporations. The probability that the Code is changed for Puerto Rico is currently very remote; however, the U.S. Congress may eventually grant Puerto Rico’s municipalities and public corporations access to Chapter 9 if faced with less democratic alternatives (e.g., a federal control board) or disorderly outcomes. Providing Puerto Rico’s issuers retroactive access to Chapter 9 is controversial, but would provide the island an effective avenue for imposing haircuts on holders of public corporation debt if upheld.
Puerto Rico’s legislators will return from summer recess on August 17. Several members of the governor’s own Popular Democratic Party (PDP) have recently dissented from the governor’s agenda, including with his failed bid for comprehensive tax reform. It is possible that the PDP, which maintains a majority in both chambers, coalesces ahead of the next general election (gubernatorial, municipal and legislative) in November 2016. Such an occurrence may allow the governor an easier path to implementing recommendations of the Working Group for the Economic Reform of Puerto Rico. The politics of Puerto Rico will play an even larger role in determining outcomes as the election nears.
Key upcoming dates:
Our fundamental outlook for Puerto Rico has not changed, but will evolve with clarity on the committee’s recommendations. Krueger’s supply-side reform recommendations are vital to a turnaround, but we question many of the assumptions, including the pace at which growth may return to Puerto Rico. Several key recommendations also depend on decisive federal action, including exemptions to the federal minimum wage and the Jones Act. The willingness of the U.S. Congress to consider these items is uncertain at best. Puerto Rico will eventually adjust, but it will be a bumpy road that may involve several years, trial-and-error and substantial debt relief.
Q: PR currently represents approximately 25% of the high yield muni bond index. Does that mean that you are pursuing other opportunities in PIMCO’s high yield muni strategies?
Deane: Actually, the high quality segment of the muni market has become far more compelling than the near-all-time-low yield levels we witnessed in January. Ten- and 30-year AAA munis have increased by roughly 50 basis points (bps) and 80 bps, respectively, since then. And with the glut of higher-quality current refunding issuance we have experienced year-to-date, A and AA rated munis are at the widest spreads to AAAs we have seen in the last few years.
On the other hand, we remain cautious about the high yield segment. Some managers still have large allocations to PR, so if the island moves ahead with a debt moratorium (or, in other words, a restructuring) of multiple credits, those funds may experience redemptions. At the same time, for the sub-investment-grade segment other than PR and master settlement agreement (MSA) tobacco debt, spreads are as tight as they were before the 2008 credit crisis. So we don’t view the risk/reward profile of the lower-rated segments as attractive – any redemption-driven selling of high yield bonds will likely drive spreads much wider. So we are maintaining a bias to higher credit quality in our high yield strategies, which is a reflection of our current views and, in fact, is generally reflected in an average rating closer to investment grade.
Q: Can you discuss PIMCO’s high yield muni strategy’s positioning and potential role in an investor’s asset allocation?
Hammer: Our top-down investment process has led us to shorten duration – both by selling longer-dated bonds and hedging with rates – as well as to move up in quality and focus on liquidity. PIMCO expects the Fed to begin to gradually raise rates later this year, and, due to the lack of dependable market liquidity, the municipal market is particularly vulnerable to any volatility arising from a Fed liftoff. Broker-dealer holdings of municipal bonds have declined from $50 billion–$60 billion in 2007 to $10 billion–$15 billion. At the same time, muni mutual fund assets have increased from $300 billion to $600 billion. The net effect is that when periods of higher rate volatility lead to outflows, prices and spreads can become significantly more volatile. This can be a great opportunity for investors who are well positioned for it, but a landmine for those who aren’t.
While the last few years have been a good time to be long, risky and levered, times and conditions have changed. We believe it is vital for investors to incorporate forward-looking conditions into their allocations.