Puerto Rico – Has The Default Train Left The Station? by Columbia Threadneedle Investment
- Defaults on all types of Puerto Rico governmental debt appear almost certain.
- Current investors should brace themselves for an extended period of receiving no interest income and additional price volatility.
- Prospective investors should consider waiting for another train.
By Chad Farrington, CFA, Senior Portfolio Manager, Head of Municipal Credit Research and Matthew Stephan, Senior Municipal Credit Analyst.
The first payment default on Puerto Rico governmental debt is likely to occur Monday, August 3, when the Commonwealth is expected to miss a payment on debt issued by its Public Finance Corporation (PFC). This may come as a shock to some given that the debt service payment due is relatively small. However, we believe it foreshadows how the Commonwealth will treat different forms of debt as it moves down the line toward restructuring its debt. PFC debt is effectively unsecured – it is backed only by a moral obligation pledge of the Commonwealth. Payments are subject to legislative appropriation – the weakest form of debt in a distressed situation. The Commonwealth and its advisors had previously indicated a preference for an individual credit-by-credit approach to restructuring. So earlier statements about being able to meet certain obligations as agreed and this failure to appropriate for PFC debt provide insight into how things are likely to play out from here.
Given the large amount of outstanding secured bonds and the possibly significant amount of debt relief required to get the Commonwealth back on track, defaults appear almost certain on all types of Commonwealth debt. But similar to Detroit and other recent defaults in the municipal market, legal protections are likely to matter and will result in a wide range of recovery outcomes. Unfortunately, the restructuring process will probably not be as clean or as fast as it was in Detroit, especially since Puerto Rico has no organized framework to reorganize such as Chapter 9 of the Bankruptcy Code. Differing levels of bond security and numerous investors with different agendas could result in lengthy negotiations and litigation. While it is difficult to determine recovery at this point given dated and limited information, we are confident that certain types of constitutionally protected and special revenue secured debt will fare better than other debt.
While we expect defaults on other Commonwealth debt in the near term given the government’s limited liquidity, we believe a Puerto Rico Electric Power Authority (PREPA) debt restructuring or default will be the next big derailment, as restructuring negotiations have been ongoing for close to a year. The government’s comprehensive, detailed restructuring proposal is due at the end of August. In the meantime, current investors should brace themselves for a potentially extended period of receiving no interest income and additional price volatility. Prospective investors enticed by the extremely high yields and severely discounted dollar prices of Puerto Rico bonds should consider waiting for another train.