MuniLand

Puerto Rico’s bond rally and economic contraction

Reuters and others have reported on the recent rally in Puerto Rico bonds.

The S&P Municipal Bond Puerto Rico Index is up 4.94 percent so far this year, with most of that increase happening in February. That same index fell more than 20 percent in 2013, when net outflows in Puerto Rico-oriented funds totaled $20.2 billion, or 28 percent of $83.4 billion in assets under management, according to Lipper data.

The primary spur for the February rally in Puerto Rico bonds was the investor call held by the Government Development Bank on February 18. The GDB had held its previous investor call on October 15, 2013 and it hadn’t issued any financial information in the  four months between calls. Investors were starved for information aside from the monthly Economic Activity Index data issued by the GDB.

Looking back over my previous writing, another big movement in Puerto Rico bond prices caught my attention. This was the violent 40 percent spread widening of Puerto Rico general obligation bonds that happened between August 28 and September 3 last year:

The late August spike in yields dwarfs the recent rally. Was there an unknown credit event for Puerto Rico in late August? Actually that is when Puerto Rico did a massive amount of borrowing, mostly away from the public markets (only the August 29 highway deal was done as a public offering).

 

In the three-week period after the Puerto Rico borrowed at least $1.34 billion, the commonwealth’s spreads blew out 40 percent. I assume that some investors that were privy to those deals had up-to-date financials. Since it’s difficult to short bonds in muniland, I assume that investors either dumped their current holdings to invest in the new offerings or didn’t like what they saw on Puerto Rico’s financial statements and sold their holdings to reduce exposure. The price moves of late August to early September dwarf the recent February rally in size.

Puerto Rico partly opens the kimono

Puerto Rico held a long-awaited investor call on Tuesday. In a highly scripted performance, participants delivered statements that accompanied the presentation slide deck. The call lasted one hour and 20 minutes and no questions from attendees were answered. Written questions submitted two weeks prior were addressed. Important issues of government liquidity and the proposed 2015 budget were briefly detailed.

Puerto Rico Governor Alejandro Garcia Padilla, in a pre-recorded talk, opened the call with an update on the commonwealth’s fiscal and economic progress over the last 13 months. He said that he was proud to have acted rapidly to address problems that were created years and possibly decades ago. He said that politics have been put aside.

Government solvency and the Government Development Bank’s (GDB) liquidity are the key focus for investors. Incomplete data made it hard to assess whether sufficient cash flows exist to service short-term liquidity needs and repay additional debt service for a proposed $3 billion dollar general obligation debt offering.

Puerto Rico’s funny labor data

 

The Federal Reserve Bank of New York made a big splash by pre-announcing that the Bureau of Labor Statistics would revise the employment data for Puerto Rico upwards. Here are the revisions that the NY Fed says that the BLS will make:

Oddly the BLS website shows different employment figures for Puerto Rico than what the NY Fed references. The BLS shows Puerto Rico employment as 1.04 million in June 2012 (an unemployment rate of 14.1 percent) versus approximately 1.01 million in June 2013 (an unemployment rate of 13.2  percent). The decrease in the BLS unemployment rate is due to a large shrinkage in the labor force of 40,322 year over year.

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.

A plan for Puerto Rico

Puerto Rico’s governor, Alejandro García Padilla, announced a six point plan to restructure the government in light of the credit rating downgrades by Standard & Poor’s and Moody’s.

He opened his speech that was delivered live on Monday:

In these difficult times, I want to speak personally to each citizen, whether in the living room or the balcony of their homes. I want talk about the budget of Puerto Rico, the current situation and how we face it together. It is time to pay bills that others left without paying.

The governor went on to outline six steps the government will take:

1. We will reduce the budget $170 million in current fiscal year. Much of the reduction will be in contracts with agencies. To be clear, we will succeed without employee dismissals.

Puerto Rico’s liquidity

If you dig a little deeper than what is generally reported on the S&P downgrade of Puerto Rico, a few facts seem to diverge from the conventional story line. The most important relates to the “liquidity” of the Puerto Rico’s government and its fiscal agent the Government Development Bank (GDB).

Puerto Rico officials have made repeated statements about the commonwealth’s liquidity and market access, saying that it has adequate funds to make all repayments required through June 30. They repeated these statements on February 4 in a press release:

‘We are confident that we have the liquidity on hand to satisfy all liquidity needs until the end of the fiscal year, including any cash needs resulting from today’s decision. In addition, the GDB and the Commonwealth of Puerto Rico have been in discussions with parties that have expressed an interest in arranging additional liquidity for the Commonwealth, and the Commonwealth continues to explore such options, including obtaining additional funding, as necessary.’

S&P downgrades Puerto Rico: The turning of the wheel

Photo: Puerto Rico Treasury Secretary Melba Acosta (R) and Governor Alejandro Garcia Padilla at a press conference in response to S&P’s downgrade. (Source: Ustream) 

Standard & Poor’s has stepped forward as the first major rater to strip Puerto Rico of its “investment grade” imprimatur. Puerto Rico is now officially speculative-grade credit and the most widely held junk bond in muniland.

Considering the economic fundamentals, the downgrade was inevitable. Economic indicators in Puerto Rico have been plummeting with sales of cement crashing 16 percent last year and gasoline consumption dropping 5.3 percent in the same period. Bank capital in Puerto Rico has declined 4 percent year over year as the commonwealth shakes off lingering problems from the housing bust.

Puerto Rico’s solvency may hang on a potentially unconstitutional corporate tax

Last June, I asked if the U.S. Treasury was bailing out Puerto Rico with an unusual interpretation of the federal tax code. This waiver or exemption allowed U.S. multinationals operating in Puerto Rico to credit taxes that were paid to Puerto Rico on their federal tax bill. The tax, referred to as Act 154, was passed by the Puerto Rico legislature in 2011. It brought in approximately $1.6 billion in 2011.

When preparing its 2014 budget, Puerto Rico had a massive $1.5 billion deficit to fill. The governor had proposed expanding the “sales and use tax” (SUT or Cofina) by 73 percent, but this was met with strong resistance from the business community. The corporate excise tax (Act 154) was raised and part of the budget deficit was filled (an $800 million deficit is still projected for the current fiscal year).

Last week an excellent explanation of the corporate excise tax was published by Martin Sullivan on The Tax Analysts Blog. Sullivan highlighted the tax’s importance at 20 percent of general fund revenues:

Negative signals from Puerto Rico

The condition of Puerto Rico’s economy is a key concern for bond investors and rating agencies. Although its tax revenues have risen sharply as the government has increased various taxes, the economy has been contracting. From a recent Morningstar report:

The contracting economy remains a core concern for us, as Puerto Rico has now experienced 12 consecutive months of economic contraction relative to last year, and the monthly decline in economic activity in the first half of fiscal 2014 has been the most rapid since fiscal 2010.

Puerto Rico measures its economy using the PR Economic Activity Index. The EAI is made up of four components: payroll employment, cement sales, gasoline consumption and electricity generation. Although most December economic figures have not been publicly released, Standard & Poor’s ominously placed Puerto Rico general obligation and appropriation debt on “CreditWatch with negative implications” on January 24th. S&P rates Puerto Rico BBB-, its lowest investment-grade rating:

Will Puerto Rico sell general obligation bonds?

The New York Times reported that Morgan Stanley is shopping a potential $2 billion general obligation bond deal for Puerto Rico. Bloomberg followed up with a story that had a few more details about the offering that Puerto Rico supposedly has not authorized. According to Bloomberg the possible deal terms are:

The taxable general-obligation deal said to be under discussion would have maturities of at least five to seven years. The funds [hedge funds and distressed debt buyers] would assist the commonwealth as it struggles to turn around its shrinking economy. The discussions have cited possible yields of about 10 percent, the people said.

Let’s break this proposed issue into several pieces:

Taxable: Issuing taxable municipal bonds makes sense because it attracts a broader base of investors (including hedge funds, commercial banks and some insurance firms) outside of muniland that don’t take advantage of the municipal bond tax exemption. But the extremely high interest rate is a signal to any bond investor that the security has very high risk, regardless of its investment-grade rating from the three major raters. So we can rule out banks and insurance companies as buyers.

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