Puerto Rico’s black swans
Puerto Rico is a small island with a population of 3.7 million people and a municipal debt load of $104 billion. Only Florida, Illinois, New Jersey, New York, Ohio, Pennsylvania and Texas – states that are all substantially larger – have more debt outstanding. Puerto Rico’s government has been financing its deficits with bond issuance, although it recently vowed to put an end to this practice in 2014. The island’s economy has been contracting for several years, but recently it began to move slowly toward positive growth. Puerto Rico’s labor market is similarly weak, with an unemployment rate of 15 percent, nearly double the national rate of 8.1 percent.
In short, Puerto Rico’s debt-to-GDP load and unemployment rate are greater than those of any state in the country. It’s on a knife’s edge, and it’s easy to imagine several black swans that could precipitate real fiscal distress.
Puerto Rico’s bonds enjoy some special qualities that keep demand for it at high levels. The island’s municipal debt enjoys a triple-tax-free exemption across the country, meaning that investors in any state do not have to pay federal, state or local taxes on it. Wealthy bondholders in high-income tax states like New York and California can earn more yield by purchasing tax-exempt Puerto Rican debt than they could if they purchased the bonds of other states. Moreover, many municipal-bond single-state mutual funds are able to take advantage of this tax-exempt status and invest in Puerto Rico’s bonds. For instance, a mutual fund that is nominally invested only in California bonds is allowed to own Puerto Rico bonds as well, but not bonds from Texas or New York.
Despite being widely held, Puerto Rico’s bonds rank near the bottom of the investment grade scale, and there are a lot of opinions about how risky they are. A new bond investing website, Learn Bonds, recently interviewed two big mutual fund managers with opposing views on the island’s debt. Marc Prosser from Learn Bonds first interviewed BlackRock’s Peter Hayes:
Peter thought the credit risk on many PR bonds outweighed the benefits of extra yield. One of the concerns he has with Puerto Rico is that the economy is not diversified and focused heavily on tourism.
Prosser then interviewed Rochester Funds’ Scott Cottier, who oversees that firm’s municipal-bond mutual fund division. Cottier believes that Puerto Rico’s debt is a good investment because its government is reducing spending and increasing revenues; because pension liabilities have flatlined; and, most important, because the federal government would step in to backstop its debt if it were to default.
In a March commentary, Breckinridge Capital Advisors, an institutional and private-client fixed-income portfolio management firm, identified a number of trigger events that could possibly cause Puerto Rico to default:
- Ratings downgrade
- Elimination of the tax exemption
- Mutual fund redemption from rising interest rates
- Federal government cuts to Puerto Rico’s transfer payments
Breckinridge did not include an economic slowdown on its list, but I think with Puerto Rico’s high level of leverage it should be included. Breckinridge sums it up:
Although the threat is not imminent and the risk remains slim, Breckinridge believes the possibility of a default by Puerto Rico is sufficient to warrant the attention of municipal investors.
A Puerto Rico default would have negative market implications. High grade investors should understand the Commonwealth’s fiscal problems because a default might trigger mutual fund redemptions and bouts of illiquidity.
However, Puerto Rico’s debt situation is unique and unparalleled in the United States. A debt crisis in Puerto Rico will have limited impact – if any – on the extremely remote likelihood of a U.S. state default.
If Puerto Rico’s economy picks up, its government can patch the holes in its budget. But if the U.S. economy slides into recession again, Puerto Rico will be hit especially hard. The question bondholders are asking is whether they are getting adequately paid for the risk that a black swan event might occur.