Puerto Rico’s debt limit
One of the most interesting points that Puerto Rico Governor Alejandro Garcia Padilla made in a speech on Monday after the credit rating downgrades by Standard & Poor’s and Moody’s (Fitch has since also downgraded Puerto Rico to speculative grade) is related to the restructuring of Puerto Rico’s tax code. He said:
In less than a year, propose a new tax structure allowing the best balance between all sectors of the country and promote economic development. These studies include the revaluation of the SUT to explore if it is the best alternative for all, taking into account the debt issued against that source.
SUT is the “sales use tax” that is the repayment source for $15.5 billion of Cofina debt. This debt is generally considered highly secure because of the legislative pledge of SUT revenues.
There had been discussion of Puerto Rico issuing another tranche of Cofina bonds that would have a third lien on SUT revenues, but SUT revenues have been coming in lower than projected as the economy contracts. I’ve questioned if there were sufficient revenues to leverage another bond offering on this revenue source. Puerto Rico has since announced it would switch and bring a general obligation bond to market rather than a Cofina offering.
A general obligation offering presents its own problems.
The primary problem is the Constitutional limit on the amount of general obligation debt that can be issued. The Government Development Bank (GDB) describes how Section 2 of Article VI of the Puerto Rico Constitution says debt cannot be issued if the payment of principal and interest on “direct obligations of the Commonwealth” exceeds 15 percent of “average annual revenues raised under the provisions of Commonwealth legislation” for the two previous fiscal years. “Direct obligations of the Commonwealth” are the $11.5 billion in general obligation debt of Puerto Rico.
Puerto Rico revenues are projected to be $9.5 billion for fiscal year 2014 (page 3), but they would not be included in the calculations. Revenues were $7.785 billion for 2013 (page 13) and $8.667 billion for 2012 (page 44). For the two previous fiscal years, average annual revenues were $8.239 billion. 15 percent of these revenues would be $1.234 billion. This would suggest adequate debt capacity to issue new general obligation debt since 2012 debt service was $964 million and Puerto Rico did not issue any new general obligation debt in 2013.
But the Constitution has caveats on the taxes that are used to determine the revenues in the 15 percent debt limit. From the GDB again (emphasis mine):
Section 2 of Article VI does not limit the amount of debt that the Commonwealth may guarantee so long as the 15 percent limitation is not exceeded through payments by the Commonwealth on such guaranteed debt. Internal revenues consist principally of income taxes, property taxes and excise taxes. Certain revenues, such as federal excise taxes on offshore shipments of alcoholic beverages and tobacco products and customs duties, which are collected by the United States Government and returned to the Treasury and motor vehicle fuel taxes and license fees, which are allocated to the Highway and Transportation Authority, are not included as internal revenues for the purpose of calculating the debt limit, although they may be available for the payment of debt service.
The definition also excludes SUT revenues that are pledged to repay Cofina debt. Constitutional debt limit exemptions reduce general fund revenues available for debt service by 7 percent, on average. Here are the historic debt limitations from the 2012 CAFR (page 292).
The 2013 CAFR has not been published, so we don’t have a debt limit calculation for fiscal year 2013. But if we subtract 7 percent from 2013 general fund revenues of $7.785 billion, we get $7.24 billion. Adding this amount to 2012 general fund revenue of $8.092 billion would average $7.66 billion. 15 percent would be $1.149 billion of allowable maximum debt service for the current fiscal year.
Debt service for 2014 is projected to $927 million (PDF page 14). Subtracting $927 million from $1.149 billion would leave just $222 million of new additional debt service that Puerto Rico could take on and comply with Constitutional requirements.
It’s unclear how large a new general obligation offering will be and what interest rate investors will demand to buy the deal. Some reporting has suggested a $3.5 billion offering. It doesn’t appear that the Commonwealth has the debt capacity for an offering of this size if interest rates breach 8 percent ($280 million of annual debt service). Puerto Rico more likely has the capacity to bring $2.5 billion of general obligation debt at 8.5 percent (about $212 million of additional annual debt service).
The Puerto Rico general obligation yield curve remains inverted:
Finding maturities and yields for the new offering that brings annual debt service under the Constitutional limit may be a difficult process.
Puerto Rico will hold an investor call on Tuesday, February 18th at 2:00 pm EST. A debt limit discussion would be useful for both potential and current investors.