Next to Detroit, the municipal entity I receive the most questions about is Puerto Rico — and rightly so. Puerto Rico faces economic and fiscal challenges unlike those in any state; and because Puerto Rico bonds are exempt from federal, state and local taxes in all 50 states, they are very widely held.
The situation in Puerto Rico can hardly be encapsulated in a single blog post, but I wanted to point out a few key considerations (good and bad) and offer some suggestions for investors.
The bad news on Puerto Rico has been well publicized, so I’ll start there.
Deep debt: The Commonwealth has a significant amount of debt. In fact, the amount of debt relative to the island’s gross national product (GNP) is roughly 85%. Compare that to the worst state, which is closer to 9%. Puerto Rico simply does not have the money to cover its bills. The gap in the general fund budget has ballooned to approximately $2 billion for fiscal year (FY) 2013.
Shallow economy: Puerto Rico also has a narrow economy that has been in a recession since 2006. Unemployment has been above 10% since the start of that recession and currently is just above 14%. The tax base is not at all healthy, housing affordability is worse than most places on the continent and costs on the island are high. Consider that power costs roughly 26 cents per kilowatt there vs. just 9 cents for the U.S. states, and the island still has the burden of complying with U.S. Clean Air laws.
Pension pain: Perhaps the number one issue in Puerto Rico relates to pension liabilities and lack of funding. The island’s three major pension systems are funded at less than 10% today; the U.S. average is about 73% and the worst state (Illinois) is approximately 43%.
Not bad … vs. sovereigns: Puerto Rico’s debt numbers look pretty dire compared to U.S. states, but they are not much different from other sovereign entities, including the United States.
Genuine effort: The new administration in Puerto Rico has been very active in proposing measures and taking steps to free up liquidity and to ease the ailing pension system. In fact, we would award the island a solid “B” on its efforts to fix its finances. Policymakers have made changes to the pension system, raised existing taxes and created new ones to the tune of potential billions in future revenues.
The effort has been impressive, but may be a case of too little too late. Given the fiscal hole that exists and the lack of impetus for economic revival, it will be difficult to move the dial in a meaningful way.
The Ugly Truth
Junk rating in waiting?: Puerto Rico’s general obligation (GO) debt is currently rated BBB- by the agencies, still investment grade. The market sees it another way (as evidenced by the very high borrowing costs being imposed for market access). Based on market pricing, the implied rating is arguably already below investment grade.
Downgrade damage: Ultimately, a downgrade to “junk” by the agencies will mean more forced selling, as investment-grade portfolios are required to sell down their non-investment-grade exposure to remain within investment parameters.
Despite a recent uptick, the Puerto Rico index is down more than 15% year-to-date. A downgrade could result in additional loss in value — or worse, a deterioration in liquidity that would make it difficult to get out of Puerto Rico bonds.
What’s an Investor to Do?
Puerto Rico debt recently rallied as some investors appear to believe the worst has passed. However, the underlying fundamentals have not changed, and that will likely be acknowledged again by the market. Until then, the recent strength might present an opportunity for investors to pare back their exposure.
More broadly, we suggest investors keep an eye on their mutual funds. Morningstar estimates roughly 77% of U.S. muni bond funds hold Puerto Rico-related debt. Given the triple-tax-exempt nature of Puerto Rico bonds, they are popular in national and state-specific funds. Ensure that any of these types of portfolios you may own do not contain a level of exposure higher than your comfort zone.
Above all, as I’ve said before, credit research is critical. There are big disparities across credits and issuers, even in Puerto Rico. Knowing what you own can make all the difference between success and failure in the muni market today.
Sources: BlackRock, Puerto Rico Commonwealth Financial Information & Operating Data Report, Moody’s, S&P, Bureau of Labor Statistics, Puerto Rico Electric Power Authority.