Muni Pros See Rough Waters Ahead for Puerto Rico

The commonwealth of Puerto Rico and the Puerto Rico Electric Power Authority may take four to six years to restore liquidity and marketability for their debt, municipal experts told The Bond Buyer.

In written responses to a Bond Buyer survey, six muni pros said the Puerto Rico debtors will regain market confidence only through restructuring, legislative and policy change, budgetary improvements, tax reform, and other cost-cutting and revenue-generating measures.

The Bond Buyer asked: Will the commonwealth and PREPA be able to establish a steady and sustainable path to fiscal relief by the end of July, or will these entities be in worse shape in three months’ time than they are now? When will a turnaround come and what steps will be required? And will there be an opportunity for long-term investment in these entities going forward?

—Christine Albano

Michael Comes, vice president of research and portfolio manager at Cumberland Advisors: Michael Comes, vice president of research and portfolio manager at Cumberland Advisors:

We think the two entities will be in worse shape. It will take years to correct problems that have built up over the course of decades. The challenge is to grow the economy by putting in the correct policy changes that will help Puerto Rico become competitive again.

Once the liquidity situation of the Government Development Bank gets resolved we will see a thawing in the ability of PREPA and the Commonwealth's access to capital. Things will probably get worse before they get better. More needs to be done to restructure the island's economy from being mostly concentrated in manufacturing, to a more advanced, services-oriented economy. A start would be to remove U.S. government tax incentives to subsidize manufacturing. Energy costs are also an issue, so a switch from oil fuel-powered generation to lower cost natural gas would also help.

Phil Fischer, head of municipal bond research at Bank of America Merrill Lynch: Phil Fischer, head of municipal bond research at Bank of America Merrill Lynch:

Puerto Rico's fiscal challenges stem, in large measure, from the sunset of section 936 of the federal tax code in 2006. Section 936 allowed profits earned by U.S. corporations in Puerto Rico to be federally tax-exempt.

For 20 years between 1986 and 2006, as the value of 936 subsidies increased, the Government Development Bank's Economic Activity Index (EAI) grew roughly 60%. In the nine years since, however, the EAI has fallen roughly 19%. It took a long time for growth to take hold, and it stands to reason that Puerto Rico's economic devolution will take time as well. The end of 936 -- coupled with growing poverty levels and accelerating out-migration - lead to the unfortunate conclusion that this is a continuing process with a horizon in years, not weeks.

The short-term looks troubling for Puerto Rico, given the government's recent statement that it will not have the resources to meet all of its obligations in fiscal 2016, and that a possible debt moratorium or claw back of otherwise legally pledged revenues could be in the cards.

In terms of PREPA, there is no clear short-term solution. The market generally expects the authority to default or enter into a distressed exchange on or before 1 July. The bond trustee has already warned that it only has $236 million in its reserve fund, an amount insufficient to meet debt service obligations due on July 1.

It is important to emphasize that Puerto Rico as a political entity and geographic presence will outlive its financial difficulties. To be sure, Puerto Rican officials value access to the capital markets, and over time, will reestablish it.

For the commonwealth long-term, it is necessary to fix the economy and stem the outflow of its citizens. Also, it is now well demonstrated that the commonwealth's status as a territory is a significant contributing factor to its current challenges, and in that respect, a clarification is important for long-term stability.

PREPA, meanwhile, badly needs to modernize its plants to remain compliant with federal regulations, as well as alleviate the costs to its residents. Only Hawaii's citizens pay a higher cost for their electricity. This is a significant engineering problem as well as a financial one."

Dick Larkin, director of credit analysis at Herbert J. Sims: Dick Larkin, director of credit analysis at Herbert J. Sims:

Puerto Rico's medium and long term outlook is dismal unless it solves its current financial crisis to the satisfaction of investors that have lent them billions of dollars. Without that, P.R.'s ability to borrow is doubtful, at best. It will be like trying to stay afloat without a life preserver.

Picture this: Puerto Rico is at a river bank, and across the river is the promised land: stable finances, partnerships to revive Puerto Rico's tourist economy, and a concerted private/public plan to diversify the economy and take advantage of Puerto Rico's educated work force. But, the river is 100 feet wide, 50 feet deep, with a current of 100 mph. Unless the collective leadership -- elected, appointed and entrepreneurial -- can get past this obstacle, future endeavors will be fruitless.

If Puerto Rico fails to swim past this obstacle, there is a waterfall equivalent to Niagara Falls, waiting to claim another victim. Right now, Puerto Rico's elected and appointed leadership is doing little more than the "dead man's float."

I've seen other distressed governments avoid bankruptcy and recover, but it takes hard work and determination. I don't see that integrity and determination in Puerto Rico's collective leadership - that's why I believe that bond defaults are inevitable. Politics and lack of leadership debilitates Puerto Rico's hopes for economic and financial improvement for the near and long-term future.

Financial conditions for Puerto Rico and PREPA will definitely worsen, because of the inertia of elected and appointed financial management to effect change.

The only thing now that will change Puerto Rico's financial fortunes is a radical change in leadership, and the rise of someone with strong financial policies that can galvanize political integrity and strong financial management. Without access to bonds, Puerto Rico is isolated, and I don't see any federal government lifelines being thrown their way.

It will take a multi-year - four or more -- demonstrated financial plan with a track record of meeting financial mileposts before Puerto Rico can ever hope to regain investment grade ratings. In New York City's financial crisis of 1975, it took over six years before they could prove they were worthy of investment grade ratings. Given Puerto Rico's lack of fiscal resolve and determination to reduce obligations to bond investors, six years may not be enough to "cut the mustard. "

Jeffrey Lipton, head of municipal research and strategy at Oppenheimer & Co.: Jeffrey Lipton, head of municipal research and strategy at Oppenheimer & Co.:

The day of reckoning for Puerto Rico has arrived. While we recognize the administration's efforts to address tax-reform, there is clearly wide-ranging disagreement between Governor Alejandro Garcia-Padilla and the commonwealth legislature. This lack of unity is an extremely negative credit event at a time when consensus is essential to prevent a systemic crisis within the commonwealth. Political posturing aside, threats of a government shutdown, efforts to amend the Puerto Rico constitution to limit protections afforded to commonwealth general obligation bonds, and a recent disclosure item stating, "The commonwealth may need to implement administrative and emergency measures in fiscal year 2016 and thereafter, which could include a moratorium on the payment of debt service or debt adjustment," all erode investor confidence.

Against this backdrop, we believe that a sustainable path to fiscal relief is a long way off. We do not envision a bailout by the U.S. government, but we strongly believe that any economic restructuring of Puerto Rico must involve an active role from the U.S. Such efforts could include tax incentives to encourage corporate investment and relocation, greater infrastructure funding, and a broader sharing of technological advances. We further believe that for any economic recovery to take hold, the government must address more aggressively the underground economy, which accounts for about one-third of the economic base and accounts for substantial revenue loss.

Budget cuts and a reallocation of resources have to be considered.

While PREPA has negotiated a 35-day extension to its forbearance agreement that buys the utility some time, it is imperative that PREPA releases a long-term restructuring plan that details how its outstanding debt will be treated and how a very costly capital improvement plan will be funded.

As we know, Puerto Rico's market access is extremely limited at best. The investor profile has dramatically shifted from retail to speculative hedge funds, distressed buyers and buyers of emerging market debt.

At this point, the market and the rating agencies aren't even thinking about a positive credit trajectory as downside risk remains.

A more manageable debt profile, a stabilized economy, and clear financial advances are all needed to lay the foundation for credit improvement. Assuming that at some point there is a turnaround, the market and the rating agencies will remain cautious and will require a number of years of consistent advances.

Ryan McDonald, credit research analyst on the BlackRock Municipal Credit Research team: Ryan McDonald, credit research analyst on the BlackRock Municipal Credit Research team:

Puerto Rico's biggest short-term problem is liquidity. The commonwealth is in need of a capital infusion -- whether through the contemplated $2.9 billion Puerto Rico Infrastructure Finance Authority transaction or a short-term deal. Without a capital infusion, Puerto Rico will be faced with a cash shortage early in FY 2016 given the seasonality of their tax collections as well as the depletion of resources at the GDB.

On top of their liquidity needs, Puerto Rico is faced with a $1.5 billion projected FY 2016 general fund budget gap. The closure of the budget gap will likely have negative repercussions on the commonwealth's economy regardless of whether the budget moves come in the form of cuts, additional revenues, or some combination of the two. Negotiations between PREPA and its creditors will truly begin in earnest after the June 1 release of the preliminary business plan by CRO Lisa Donahue. It's likely the situation continues to drag out given differences between the two parties on key issues, such as electricity rates and bondholder haircuts. For Puerto Rico to provide confidence to the market there needs to be a finalized balanced FY 2016 budget accompanied by adequate comprehensive disclosure and a five year consolidated business plan. Liquidity pressure has dictated a very condensed time frame to achieve all of these goals. Against the backdrop of failed tax reform, $1 billion to $1.5 billion in potential cuts to an $8.6 billion FY 2016 General Fund budget is massive and likely to worsen Puerto Rico's economic growth from the recently revised -0.9% FY 2014 GNP rate. There could be an opportunity for an investment in Puerto Rico bonds when the commonwealth comes up with a comprehensive fiscal adjustment plan that is achievable.

David Tawil, president, co-founder and portfolio manager at hedge fund Maglan Capital.: David Tawil, president, co-founder and portfolio manager at hedge fund Maglan Capital.:

If there isn't a consensual agreement or framework for negotiations reached or within sight, I fear that the parties will spend the next months gearing up for litigation. The difficulties of the situation are exacerbated by, one, the numerous parties that have a stake in the outcome and each with a resulting voice in the conversation, including politicians who could have very different priorities than financial stakeholders, and two, the lack of clarity on the controlling rule of law that can be applied. Because of the lack of certainty on legal framework, it only takes one party to over-play its hand and cause the entire situation to devolve. Although the price of the P.R. securities may not reflect the worse shape of the status, because GO holders may interpret a PREPA-only restructuring as an in-the-clear sign for the commonwealth generally, all the entities at issue will not be in better shape until a financial restructuring for each entity is consummated.

I expect worsening before getting better because typically in over-levered situations, circumstances don't improve until the financial restructuring has been achieved or is clearly in-sight, and the interested parties can focus less on the financial terms of the deal and more on the operational improvement. Right now, every stakeholder is focused on 'the deal' and not on any fundamental improvements to Puerto Rico's infrastructure and economy.

Comments (2)
Sirs: If the State of IL doesn't fix its pension mess - and there is an actual (or disguised) default of any kind - watch for Puerto Rico and others to jump on the wagon in hopes of Washington bailing them out with its printing press. J. H. Noonan, CEO Argent Resources Corp. Chicago
Posted by John N | Tuesday, May 12 2015 at 12:56PM ET
Mr. Comes surely is unaware that manufacturing provides more than 30% of the income to the Puerto Rico treasury. If manufacturing incentives in Puerto Rico are eliminated how is Puerto Rico going to create the capital to pay down its debt?
Posted by Jose G | Tuesday, June 16 2015 at 9:07AM ET
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