Bearish on Puerto Rico
Tax-exempt investors have their own special metabolism. They seem not to react to bad news until someone presents them with an old newspaper and commands them to sit down and read it. The facts seem to startle the coupon clippers—why did no one tell them?— whereupon the market goes to pieces. Certainly, such was the case with Puerto Rico last summer (Grant’s, April 5, 2013). The commonwealth didn’t rack up all that debt by itself; a sleepy and guileless bond market was its co-dependent.
Grant’s Interest Rate Observer on Puerto Rico, May 2, 2014
Grant’s Interest Rate Observer’s research on Puerto Rico has been accurate and far-seeing. Its founder and editor Jim Grant has a reputation as a fixed-income analyst. His son, Charles Grant, studies Puerto Rico’s financials.
In a phone interview, Grant commended the Puerto Rico government for its effort to pay its debts. But, given the commonwealth’s population decline and low labor participation rate of around 40 percent, he is unable to discern any long-term plan to right size the government’s debt load. He wrote in a recent commentary:
‘We’ve proved that Puerto Rico is not Detroit and not Greece,’ Governor Alejandro Garcia Padilla boasted to Bloomberg on April 9, a month after the successful sale of $3.5 billion in Puerto Rican general obligation debt. The 8s of 2035, rated Ba2/BB+/BB and priced today to yield a triple-tax exempt 9.07 percent, constitute the largest speculative-grade muni bond offering on record. No doubt, Puerto Rico is neither Greece nor Detroit. Still, the commonwealth’s finances are under strain. Grant’s expects that, sooner rather than later, some of its $72.8 billion of debt, spread across 1,500 separate cusips, will be restructured.
Grant admitted that the newly issued 8s of 2035 could turn out to be the muniland “trade of the decade” if Puerto Rico is able to restart the economy. Because there is enormous risk, they are only appropriate for investors with very high risk tolerance.
What is Grant’s top candidate for potential restructuring over the next few years?
Puerto Rico Electric and Power Authority: PREPA, with its $8.5 billion in debt outstanding and consistent record of operating at a loss when interest expense is added to operating expenses, would be a prime candidate for restructuring. Puerto Ricans pay more than twice the national average for power (24-25 cents per kilowatt hour vs. 12 cents for the national average), a clear hindrance to business activity. Most PREPA paper ‘trades’ between 65 and 75. Caribbean Business revealed on Thursday that a November 2012 report on the utility undertaken by a consultancy on behalf of the GDB, which had been confidential, valued the utility at $3.5-$4.1 billion. At the time of the report, $6.9 billion in debt was outstanding.
The Puerto Rico legislature is discussing ways to make PREPA more efficient, but the market price of PREPA bonds supports Grant’s view of a likely restructure down the road.
Like me, Grant has concerns about the fragility of the tax structure that provides support for the general obligation bonds. Grant writes:
Red flags abound in the GO bond prospectus. Law 154, the corporate excise tax which represented roughly 20 percent of general fund revenue in fiscal years 2012 and 2013 and has accounted for 22 percent of fiscal 2014’s revenue through nine months, applies to a strikingly short list of companies, it comes to light. During fiscal 2013, ‘the special temporary excise tax [due to expire in 2017] was paid by 27 groups of affiliated taxpayers, of which six groups accounted for approximately 75 percent of collections.’ Not exactly a diversified revenue stream.
Grant pointed out that upcoming April and June tax collections are critical. They will determine if Puerto Rico will end the fiscal year with a deficit under $600 million, as projected. The tax collections will also provide an important clue for how likely a balanced budget is for fiscal year 2015. Grant lauded the recent enhanced transparency of the Government Development Bank and the Office of Management and Budget.
Puerto Rico is a complex issuer to analyze. There are many entities that issue debt and rely on cash flow payments from each other to meet debt service. Many critical documents are in Spanish and most of the required regulatory filings are published after the deadlines. The younger Grant has taken on a tough issuer, but I think his analysis will continue to serve his clients well.