Here to help put Puerto Rico’s debt issues into perspective 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 Tuesday, July 15, 2014.
Legislation passed to allow restructuring of Puerto Rican debt. Why was the legislation passed, and what agencies might likely consider restructuring?
The commonwealth really has not been able to turn around the economy. Things have gotten a little bit better, but year-over-year economic growth was still, I believe, negative 1% (plus or minus 1%) in Puerto Rico. Puerto Rico continues to be negative on a year-over-year basis. So I think investors were becoming concerned about the ongoing negative economic environment, and the government started to turn its back on some of the local agencies and place the blame on the lack of economic recovery specifically on the Puerto Rican electric utility, which is referred to as PREPA in the bond market, saying power costs were too high on the island and that was the reason why they couldn’t stimulate the economy. It was the reason why manufacturers and businesses didn’t want to relocate to the island. And so they put forth a proposal that would allow the restructuring of agencies, specifically saying it was applicable to PREPA and to PRASA, which is the water and sewer system, and the Puerto Rico Highway Authority. They did exclude, specifically, the general obligation credit COFINA, the sales tax–backed bond, the university system, the local municipals, and then also the Puerto Rico Public Builders Association. So again, they were very specific about which entities could potentially restructure. Now, they did say that they had no intention of actually using these restructuring laws, but they wanted to have the ability to do it—and they wanted to have the ability of these agencies to stand on their own.
Sounds like a lot of activity going on. And yet ratings agencies downgraded much of the debt. Who’s affected?
The rating agencies, both Moody’s and Fitch, took action not only on the agencies that I mentioned—the electric system, the highways, and the water and sewer system—they also then proceeded to downgrade the entire municipal Puerto Rico complex. For many of those named, it was a large downgrade. In the case of Puerto Rico Electric, I believe they were rated double B by Moody’s and Fitch prior to the announcement, and I believe they are now in the triple-B category. The GO [general obligation] credit saw a multiple notch downgrade. And then they also downgraded COFINA, the sales tax structure, which was rated single A, I believe, by Moody’s, and it was downgraded, I believe, to the single-B rating category—and Fitch downgraded them from double A- to double B-. Now S&P is the only rating agency that still rates them investment-grade, but you saw a substantial sell-off in prices, further sell-off in the Puerto Rico Electric name, further sell-off in the highways and some of the GO debt and some of the university debt, and then the COFINA structure, again the sales tax bond, you saw a fairly substantial sell-off as well. The new ratings in the junk category by both Moody’s and Fitch will now take them out of the investment-grade category, and Puerto Rico will now make up roughly 32% to 33% of the actual high-yield muni index.
Has any of this affected you and the team?
For us, we’ve been fortunate in that we’ve had very limited exposure to Puerto Rico. What we do own is higher quality. It’s insured paper, and it’s performed much better than the broad indexes from an overall perspective. I think on a go-forward basis it makes it very hard to analyze what the recovery value will be in the Puerto Rico complex. Will they have liquidity? Will they be able to access the markets on a go-forward basis? While distressed investors are in, and buying and prices seem to have stabilized near term. The questions we have are: Will retail continue to sell? Will other high-quality mutual funds continue to sell because they now own high-yielding debt or the below-investment-grade-rated debt? And ultimately, how might all this impact entities that were not part of that restructuring bill?
And yet, investors fear, or stay away from completely, any bond with the name Puerto Rico in it. Justified?
You really need to look under the hood. Look at the capital structure of these organizations. There are certain credits, some private universities, some bonds that are backed by direct payments from the U.S. HUD organization [Housing and Urban Development], bonds that are insured by names like National RE or the old MBIA, Assured Guarantee, and even Berkshire Hathaway, I believe, insures some Puerto Rico debt. Even if Puerto Rico were to default, many of these bonds would continue to pay. We’ve been active in some of those issues. We’ve been buyers of short-term debt that’s backed by National RE and short-term debt that’s backed by Assured Guarantee, where we have confidence that those monoline insurers who, even if the entire Puerto Rico complex were to default, would continue to make principal and interest payments for the foreseeable future.
That is all the time we have, Lyle. Thanks for joining us again here On the Trading Desk.
Thanks for having me, Aldo.