Putting Puerto Rican debt into perspective (excerpt)

Lyle Fitterer: Putting Puerto Rican debt into perspectiveHere to take us beyond the headlines is Lyle Fitterer, CFA, CPA, managing director of Wells Capital Management’s Municipal Fixed-Income team, in this excerpt of On the Trading DeskSM from Friday, February 14, 2014.

Lyle, was this downgrade news to the industry or to you?
I think it was news in terms of how long it took for the downgrade to occur. We’ve rated the debt of Puerto Rico non-investment-grade, probably for over two years now. The market had anticipated it as well. So, not unexpected.

So help us understand, which debt was downgraded specifically?
Consistently, the GO was downgraded, the general obligations of Puerto Rico. All three [rating agencies: Fitch Ratings, Moody’s Investors Service, and Standard & Poor’s] still have them on negative outlook. Away from the GO bonds, almost all the debt other than the COFINA structure [the Spanish-language acronym for the Puerto Rico Sales Tax Financing Corporation], a few of the agencies, and some private universities, was effectively downgraded to non-investment-grade.

And how far-reaching is the problem? I mean, how dire is Puerto Rico’s financial situation?
Well, it’s a work in progress. The current administration, which came into office last year, has made a lot of difficult decisions in terms of cutting expenses, reforming the pension plans, passing legislation, to increased taxes, which have increased revenues at least temporarily. And they’re well on their way to actually, for the first time in a long time, potentially having a balanced budget. Now, that’s contingent, I think, on the economy turning around and some further cuts from the expense side of the equation. But the biggest problem that Puerto Rico has is really from an economic perspective. They released December data, and it showed year over year, the economy declined at about 5.2%. So, even if you’re raising revenues, or raising taxes, or cutting expenses, as we all know, it’s very difficult to effectively tax your way out or even cut your way out of a declining economic situation.

A 5% decline in the economy, that’s pretty big. I thought Puerto Rico was closely tied to the U.S., and we’ve had slow growth, but growth, nonetheless.
The amount of debt outstanding has grown substantially over the last 10 years. But probably more importantly is some of the tax-exempt incentives for some of the pharmaceutical companies have run out, so you’ve seen several years of declines in what’s one of their larger manufacturing sectors. It’s all going to be based on economics, right? If the cost of energy is high, if taxation continues to go up, which they’ve increased taxes now on many businesses, it becomes less of an incentive to be there. And I think that’s why you’re seeing actual economic decline in the Commonwealth versus the U.S., where we’re on our fourth or fifth year of economic growth.

And then my other question is, why are they having this problem?
I think, for many years, their structural deficit was anywhere from 15% to 37%. And for many years, they had fairly easy access to the capital markets. They could continue to basically finance that deficit through the debt markets. It’s been very similar to what happened to a lot of individuals in the U.S.—easy access to cheap money, and all of a sudden that access to cheap money goes away and you get a decline in your assets and you can’t service that debt anymore. That’s the situation Puerto Rico is in.

Are some bonds less affected, Lyle, by the debt downgrade—bright spots shining down on the island?
There are a lot of issuers in Puerto Rico. Some of them are backed by defined revenue streams, like Puerto Rico Electric, which is referred to as PREPA. The COFINA sales tax bonds are backed by a specified revenue stream. There are some private universities in Puerto Rico that actually are benefiting from the fact that the public universities are getting less funding and are therefore seeing students leave the public universities and migrate to some of the private universities. So their debt profiles actually look OK. They can continue to service their debt. And then, finally, there’s some very short-term debt that is insured by the likes of National Public Finance Guarantee or Assured Guarantee, which we think has good claims-paying abilities for many, many years to come. So we’ve played it from that perspective, where we’ve been involved in Puerto Rico. And again, where prices are currently, there might be some opportunities. If they get this deal done, which provides them liquidity for the next two to three years, it could be an opportunity where you could see some sort of relief rally. We’re just not sure exactly where we are, though, on that cycle. So, we haven’t really been dabbling in the longer, lower dollar price, unsecured, or GO type of debt just yet. But within our marketplace, that’s a very rapidly developing situation, and so it could present further opportunities down the road.

Lyle, we’d welcome a parting thought for investors if they’re still nervous about Puerto Rico.
I think people need to understand that the rating movements are not going to necessarily be the biggest drivers of price performance on Puerto Rico bonds. As we all know, the rating agencies many times are late to the game. I would say, just sit back and think about your strategy. Can you absorb some of this volatility? And also, if you own mutual funds, how big of an exposure to Puerto Rico do they have, and what do they own? So, make sure you know what you own, don’t be too quick to pull the trigger, and take a look under the covers.

That is all the time we have, Lyle. Thanks for joining us again here On the Trading Desk.
As always, thanks, Peter.

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