US Muni Funds Jolted By Puerto Rico’s Debt Crisis by Alec Mendes, FactSet
Puerto Rico’s ballooning debt crisis has brought much attention to the small island territory, where over 25% of working citizens are employed by the government. With yields soaring, municipal investors are scrambling to determine how today’s and potential future defaults will impact portfolios, knowing that about half of US muni funds are exposed to Puerto Rican debt (according to Morningstar). Most of this debt was purchased with investment-grade ratings by portfolio managers lured in by extremely accommodating tax laws. Puerto Rican government debt is generally tax-free in any US state, which led state-specific municipal funds to load up on island debt over the past three years.
Finding Opportunities in Distressed Debt
To understand the current state of the Puerto Rican markets and identify potential opportunities, we must dive into outstanding debt issues, as the federal government is still mulling a bailout plan and settlements between investors and the territorial government are still being negotiated.
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Starting with a snapshot of the current state of the Puerto Rican muni market, it is clear that almost all state agencies have yields soaring into junk territory. Average yield (weighted by market value) is at a staggering 17%.
To decompose how the market is pricing out the default and create a potential timeline of resolution, we can first break out the universe of outstanding debt into maturity buckets. We can then examine yields inside of these buckets to understand the yield profile of Puerto Rico, which is severely inverted. Average yields within five years are all over 20%, with short-term yields as high as 300%. Between five and 10 years, bond yields are still fairly high, as the market is signaling a haircut on intermediate-maturity bonds.
Puerto Rico Risks Third Wave of Defaults Without Comprehensive Debt Relief Plan
Examining scheduled payments by Puerto Rico over the next year, we see that interest represents a significant portion of payments that the island cannot deliver on. Unless a comprehensive debt relief plan is in place by July 1 (when a nearly $2 billion payment is due), Puerto Rico will risk a third wave of defaults in 2016. Government officials have already said the island will default on a $422 million principal payment due Monday, adding to a round of missed payments in January. This particular payment is on a bond that was rated investment-grade as late as December 2013. Annotations represent rating agency downgrades (red) and affirmations (white).
Examining recent market volatility is also important in finding potential opportunity in distressed debt. Breaking out debt into years to maturity buckets, we can look at month-to-date price changes and see that securities facing an imminent default (maturity greater than one year) have lost about 10% in recent weeks. Bonds maturing a decade or more still lost significant value, and there is trading activity in the market.
The Puerto Rican debt crisis represents a long culmination of accommodating tax regulations for mainland investors, an oversized island government, and an unusually high tax burden that was ignored by most investors until it was clear the government was going to start defaulting. Funds have already written down debt and are in negotiations on haircuts and restructuring. While markets remain extremely volatile, a solid restructuring plan could bring some calm to markets and avoid additional defaults in the coming months.
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