Puerto Rico: Can Congress Provide Relief? by John Ceffalio, Guy Davidson – AllianceBernstein
The legislation known as PROMESA stands for Puerto Rico Oversight, Management, and Economic Stability Act. “Promesa” is also Spanish for “promise.” Can the bill provide the relief it promises for Puerto Rico and its bondholders?
What the Bill Hopes to Achieve
Puerto Rico has run chronic budget deficits because of overspending and a dwindling tax base. Given its declining economy, the Commonwealth is unable to support government operations along with its pension liabilities and massive debt.
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The crux of the problem is that Puerto Rico has no ability to restructure its debts. Why? When Congress amended Chapter 9 of the Bankruptcy Code for municipalities, it explicitly left out Puerto Rico.
Unless Congress now intervenes, we expect Puerto Rico to face years of legal battles with its creditors, as well as suits between creditors, who will have to fight among themselves for whatever scraps remain.
That’s where PROMESA comes in. In its current form, the bill seeks to accomplish two major goals.
First, it would appoint a seven-member Oversight Board to take charge of Puerto Rico’s finances. We’ve seen this before: when Congress took control of Washington, D.C., in the 1990s, and when New York State imposed control over New York City in the mid-70s.
Second, the bill would create a bankruptcy-style restructuring regime in order to adjust Puerto Rico’s debts, including its pension shortfall. The restructuring would be submitted to a US district court judge for approval.
This restructuring would likely impair timely principal and interest payments for all classes of Puerto Rico’s debt, including general obligation bonds. How much each class would be compelled to concede is unknown.
Puerto Rico – July 1 Default Looms
The bill was passed by the House of Representatives on June 9. It has since moved on to the Senate.
The US Treasury, the Obama administration, the House majority and the House minority would like the bill passed before July 1, when more than $2 billion worth of debt payments are due from Puerto Rico.
If the Senate changes PROMESA, it will go back to the House to be approved again, which could put meeting the deadline in question.
Pros and Cons for Investors
While delays are possible, we think the Senate will sign off on the bill sooner rather than later. If it passes, it will create a legal framework that can be used to address the financial problems that got Puerto Rico into so much trouble.
The bill is positive for bondholders. By establishing a clear process for restructuring Puerto Rico’s debt, PROMESA eases the significant fear that today’s investors will be dealing with years of lawsuits. Predictability is always better for bondholders.
We also think that the Oversight Board will have the power to reduce Puerto Rico’s spending. The control board will be removed from the Commonwealth’s politics, where it’s also election season. The board may therefore be more willing than local politicians to make the tough but commonsense decisions required to balance Puerto Rico’s budget.
Lastly, the Commonwealth has always had problems with poor accounting standards, including financial disclosure to investors. We expect that the control board will be able to improve that as well.
Unfortunately, PROMESA isn’t perfect. It fails to address the root cause of Puerto Rico’s problems: its declining economy and population. The Commonwealth has been in recession since 2006. Since then, it’s lost 15% of its jobs, 15% of its GNP, and nearly 10% of its population.
To make matters worse, Puerto Ricans are leaving the territory at an increasing pace. These emigrants would have paid taxes that could have paid off bonds. That means less capacity to pay future debt, too.
This cycle is tough to break. However, there are some things Congress might decide to do to resolve it:
Tax incentives. Congress has a history of providing such incentives for Puerto Rico.
An increase in federally provided Medicaid money. Puerto Rico receives fewer Medicaid dollars than do states, so it has to spend more of its own cash. By righting that imbalance, Congress could make it easier for Puerto Rico to balance its budget.
Economic boosts. Generally, bondholders look to invest in sound economies that are going to grow. Positive measures for Puerto Rico’s economy—enacted by Congress—could bring bond investors back to the island. Economic boosts should curb population shrinkage as well.
Regrettably, we think it’s unlikely that Congress will take these steps—particularly with an election due in November. That means investors should be prepared to temper their optimism when it comes to recovery rates. We think recovery rates could be lower than current prices suggest.
Puerto Rico’s current situation is unsustainable. The pending legislation is a decided improvement, albeit not a sure cure because it doesn’t address Puerto Rico’s underlying problem: its contracting economy.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.