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New austerity and confidence in Puerto Rico

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Five months after Puerto Rico officials talked publicly to market participants, they held an investor call on Thursday with over 2,000 people. The call was captured by Storify. Puerto Rico’s previous call in February rallied market enthusiasm for a $3.5 billion general obligation bond offering that was priced on March 8. The March deal, the largest speculative grade bond deal ever done in muniland, replenished the coffers of the fiscally debilitated island.

Now the government is hoarding that cash and taking “swift and decisive” actions to clean up its internal capital structure. It is paying back internal loans between the central government, the Government Development Bank (GDB) and public corporations. Officials said that they had eliminated virtually all interest rate swap contracts at the GDB. They outlined new revenue sources and detailed expense reductions for general government operations.

The government reiterated that it intends to “ring fence” the debts of several public corporations while protecting their constitutionally-guaranteed general obligation debt and sales tax-backed Cofina bonds. An investor group that owns about $3 billion in Puerto Rico general obligation and Cofina debt announced that it supports the government and stands ready to assist Puerto Rico with financing.

At the opening of the call, Governor Alejandro García-Padilla said “our commitment to honoring financial responsibilities of Commonwealth remains unshaken.” Officials seemed confident and committed to imposing austerity on the government’s expenses.

“We believe that rating agencies have seriously misunderstood and misrepresented the intentions of the government,” said David Chafey, president of the Board of Directors of the GDB. Chafey stated that the government had a sufficient “liquidity runway” to sustain its capital needs, but had expected to access the market again in the short term. Chafey said that the GDB is “dedicated to working on a consensual agreement with our creditors.”

Estimating muniland bond recoveries

A lot of people in muniland have asked me how much the bonds of Puerto Rico’s electric monopoly Prepa will recover if they are restructured. I’ve thrown out a few numbers, but I don’t have an analytical tool to do a proper cash flow analysis. Chris Foster, managing director of New Oak, has published an open source model (download middle right of page – XLSM file) that allows one to adjust various inputs like fuel prices and electric rates to estimate the level of debt service that Prepa can support.

Puerto Rico

New Oak put most of Prepa’s historical financial data into the spreadsheet and creates scenarios that can be adjusted to estimate how much bondholders will have to be cut.

Foster explained that his firm, a subadvisor to funds and financial institutions, was hearing a lot of uninformed theories about Prepa. He thought modeling the potential outcomes would be helpful. His firm and their clients do not own Prepa bonds. Foster said that it was time for everyone involved “to look at the math.”

Puerto Rico’s latest debt effort

 

Puerto Rico

The struggling Puerto Rico government was sideswiped when reports emerged that the island’s Resident Commissioner Pedro Pierluisi had asked the U.S. Congress to consider amending the federal bankruptcy code.

Pierluisi wants to give Puerto Rico public corporations the right to seek protection to reorganize in federal court under Chapter 9 of the bankruptcy code, rather than use the island’s newly passed Public Corporation Debt Enforcement and Recovery Act.

The Puerto Rico government reacted with faint praise, but it failed to point out that Pierluisi’s plan, if executed, would deny Puerto Rico’s electric utitlity [PREPA] the right to haircut bondholders. This is because Prepa issues revenue bonds that are protected by Chapter 9 in the bankruptcy process. Pierluisi’s approach would handcuff the Puerto Rico government in their effort to restructure Prepa’s debt.

Municipal bond funds will survive a Puerto Rico shakeout

Puerto Rico

Barron’s had a recent story, “Puerto Rico’s Debt Woes Could Spread,” that says, “As mid-year statements go out, muni-fund redemptions could force selling of other credits.” Barron’s author Randall Forsyth wrote:

But the effects of legislation to allow restructuring of the debt of the [Puerto Rico] so-called public corporations continue to ripple through the municipal bond market. Thus far, those ripples have been contained, with little spillover into the broader muni market.

That could change, however, when holders of tax-exempt bond funds — especially the high-yield variety — get their June 30 statements. How these individual investors react to the funds’ declines from their exposure to Puerto Rico debt could hit the broader muni market if funds are forced to liquidate bonds to meet shareholder redemptions.

Puerto Rico’s whirling inferno of news

The news flow from Puerto Rico has become a whirling inferno since the government passed legislation last week to allow some of the Commonwealth’s public corporations to default.

Here are four important points for investors in Puerto Rico bonds:

1. The market is awaiting official confirmation that Puerto Rico’s teetering electric utility PREPA has made its $204 million bond payment due July 1. If made, it will relieve short-term pressure on Puerto Rico, but the intentions for restructuring are still unknown. Attention will turn to PREPA’s $660 million outstanding lines of credit with Citibank and Scotiabank that need to be renewed.

2. The credit rating agencies are finally catching up with the market and have been raining downgrades and watch alerts on Puerto Rico and its public corporations. At this point these downgrades are somewhat irrelevant, since Puerto Rico bonds are selling at junk yields and investors are more interested in possible recovery values.

Puerto Rico ring fences its public corporation debt

Puerto Rico

In a dazzling effort, Puerto Rico Governor Alejandro Garcia Padilla presented legislation to restructure the debt of several public corporations. Both the Puerto Rico Senate and House approved the measure and pushed it to conference where statutes require that it be reconciled by the end of the legislative session on June 30. Seldom have financial markets seen such an elegantly choreographed approach to haircutting sovereign debt.

For months, Padilla has promised a balanced budget for fiscal year 2015, which begins July 1. He maintained that no government employees would be laid off (although contract workers might be). The Commonwealth’s $9.6 billion general fund budget had enormous deficits. By severing the fund from the deficits of Puerto Rico’s public corporations, the general fund will be relieved from financing about $800 million a year. Caribbean Business reported:

Over the past year, the GDB has reiterated that the public debt of the commonwealth should not be seen as a sum of debts to a single debtor, but rather as individual loans supported by various sources of revenues and income, with certain priorities established by law or contract. The officials said the GDB’s message to the market has been consistent in the sense that neither the commonwealth nor the GDB is in the position to subsidize or bail out public corporations and that they need to become self-sufficient.

Puerto Rico’s electricity monopoly is in a downward spiral

Puerto Rico’s faltering electricity monopoly PREPA received another blow this week when Standard & Poor’s downgraded the public corporation’s $8.8 billion of revenue debt to BBB- (5.5) from BBB (6) and placed the rating on CreditWatch with negative implications. This leaves PREPA one small step from junk grade in the three major raters.

Rater

Rating

Quality Fitch BB

– 4.5 – Moody’s Ba2

– 4.5 – Standard & Poor’s BBB-

– 5.5 –

In August 2013, PREPA issued $673 million of Power Revenue bonds, which recently traded with a 10 percent yield for maturities due 07/01/2040 (Cusip 74526QA85 shown below). This clearly signals that the market believes these bonds are speculative grade. Standard & Poor’s low investment grade rating of BBB- is lagging the market’s view and is two notches higher than the other major raters.

PREPA

PREPA’s severe cash problems first surfaced when it was reported that the electricity monopoly had transferred $100 million from a capital construction fund to pay Venezuela’s state-run company Petrobras for oil to run its electricity generators. Caribbean Business reported:

Puerto Rico’s flat budget

Puerto Rico’s plan for a balanced budget for fiscal year 2015 is ambitious. Economic conditions continue to worsen and the commonwealth had a massive tax revenue shortfall in April. Although bondholders were a promised a balanced budget, uncertain tax collections are threatening a smooth transition away from deficit financing. There appears to be a growing political struggle as Puerto Rico attempts to cut $1.5 billion in operating expenses from a $9.6 billion budget.

The effort to achieve a balanced budget reverses years of deficit spending. In a paper, Moody’s describes the new budget: “The proposed budget carries material risks associated with its implementation and projected revenues. Despite these risks, the budget does indicate positive movement toward structural balance and avoidance of new deficit financing.”

Moody's

I’m less positive than Moody’s. Some in Puerto Rico have pointed out how spending moved up in 2012 as part of the electoral process to gain support from voters. Post-election spending fell in 2013, inched up slightly in 2014 and is expected to be flat between 2014 and 2015.

Puerto Rico stumbles on tax collections

Puerto Rico

Puerto Rico’s April tax collections suffered a big collapse. The projections were missed by 27 percent, or $442 million. The data was released last Friday. The April shortfall, caused mostly by reduced corporate income taxes, imperils year-end budget figures. It also jeopardizes the recently proposed fiscal year 2015 budget that was proposed by Puerto Rico Governor Alejandro García Padilla.

If tax collections continue to taper, either substantial additional taxes must be levied or cuts larger than the anticipated $1.5 billion will need to be made for the 2015 budget to be balanced. Bondholders have been promised that the 2015 budget will be balanced and that it will not rely on debt borrowing to fill budget shortfalls. April’s tax collections, if not made up in May and June, will make this promise hard to keep.

According to Morningstar, 67 percent of U.S. municipal bond funds (as of March 31) have exposure to Puerto Rico general obligation and agency debt. The gross market value holdings of Puerto Rico bonds held by 486 U.S. municipal bond funds increased to $12.69 billion as of March 31, from $12.51 billion on December 31.

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:

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