With the recent news surrounding the Detroit bankruptcy lingering in investors’ minds, the Commonwealth of Puerto Rico has recently been the focus of industry press. The pieces tend to focus on many of the credit negatives of the commonwealth that have been known in the credit community for a long time; specifically, its stalled economy, structural budgetary deficit, high debt and pension liabilities, below-average socio-demographics, and declining population. These realities are represented in the commonwealth’s current general obligation (GO) ratings of Baa3 (Moody’s – 10th highest of 21 ratings), BBB- (S&P – 10th highest of 22 ratings), and BBB- (Fitch – 10th highest of 20 ratings). In addition, all three major rating agencies hold negative credit outlooks for the future of the island’s creditworthiness.
While some of the articles I’ve seen do a great job focusing on the systemic risks posed by the wide ownership of Puerto Rico in mutual funds, the ultimate risk of investors in these mutual funds is the potential for a significant decline in the value of their investment because of the overweight exposure in the funds to the debt of Puerto Rico. This is especially true in the event that the commonwealth’s GO ratings fall to below-investment grade levels, triggering distressed sales by funds unable to hold low-grade bonds.
What I’ve not seen discussed as much are some credit differentiators that exist with respect to Puerto Rico’s outstanding debt that I would like to highlight.I feel that knowing what you own can turn fear into knowledge; it can turn risk into an opportunity. First, Puerto Rico is not authorized to make use of a Chapter 9 bankruptcy and is not a “municipality” as defined in the U.S. Bankruptcy Code. However, this does not mean that the government of this U.S. territory couldn’t authorize any type of ‘restructuring’ of its outstanding bonds that could negatively impact bondholders.
Second, the Puerto Rican constitution provides that the public debt of the commonwealth has a first-lien claim on all available commonwealth tax revenues for debt service payments. This provision allows for a ‘claw back’ of taxes and revenues pledged towards the payment of other bonds for the payment of the commonwealth’s general obligation debt, such as excise rum taxes, oil and gasoline taxes, or hotel and occupancy taxes. This “super lien” status can be a double-edged sword for investors since it strengthens the commonwealth’s ability to pay its outstanding general obligation debt, but would weaken the debt service coverage of the bonds that have essentially a secondary lien on the pledged revenues. Again, this claw-back risk has always been present and is reflected in the ratings of the affected bonds.
Finally, not all of the debt issued on behalf of Puerto Rico is subject to this constitutional claw-back risk. Due to the strong legal structure of the bonds issued by the Puerto Rico Sales Tax Financing Corporation (COFINA), which grants a statutory lien to COFINA bondholders, the sales-tax revenue stream pledged towards the repayment of the bonds is deemed to be separate from the commonwealth and cannot be used for payment of debt service on Puerto Rico’s general obligation bonds. It’s for this reason the credit ratings on the bonds are currently Aa3 (Moody’s – 4th highest of 21 ratings), AA- (S&P – 4th highest of 22 ratings), and AA- (Fitch – 4th highest of 20 ratings). That said, although exempt from constitutional claw back, the credit quality of the bonds is not isolated from Puerto Rico’s negative economic and financial conditions. While the Puerto Rican government has outlined a strategy to mitigate their deficit and debt problems, the situation will still warrant continued scrutiny.
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