With around $60 billion of outstanding debt, Puerto Rico has become one of the largest issuers in the tax-exempt bond market.
The U.S. territory’s ability to amass such a massive debt load has been abetted by the exemption from local, state, and federal taxes on interest that Puerto Rico’s bonds enjoy.
Depending on the outcome of Puerto Rico’s statehood vote on Tuesday, the island’s rare triple tax-exemption status may soon see its last days.
Tax law experts, analysts, and other market participants have said that if the territory becomes a state, its bonds would likely be exempt from only federal taxes, like every other state.
“Bonds issued only after a state is admitted will be treated under federal law, including under the Internal Revenue Code, the same way as all other state-issued bonds are treated under federal law,” according to a New York lawyer who has served as bond counsel to Puerto Rico.
“You can’t treat one state differently than others,” he said.
He added that legislation regarding territories that become states is determined on a case-by-case basis, and that it is up to Congress to decide on various issues.
While it is generally expected that Puerto Rico’s bonds would lose the added double tax-exempt benefit, the question remains of what might happen to the tax-exempt status of the island’s previously issued debt.
“There is nothing in the federal laws of the United States that expressly says that pre-statehood exemption on bonds that are still outstanding post-statehood has to be preserved,” said the New York lawyer.
“But fairness, and actions in connection with the admission of other states indicates that it would were Puerto Rico to become a state.”
John Mousseau, managing director and portfolio manager at Cumberland Advisors, says he would expect that the bonds would keep the triple tax-exempt status they currently enjoy in all states, which would make them more valuable.
“If the bonds get grandfathered with the status of double exemption, it would make a lot of those bonds trade up quite a bit,” Mousseau said.
Under that scenario, however, new Puerto Rico bonds without triple-tax-exemption would not be as desirable as outstanding Puerto Rico bonds.
“In a new world where there’s no double exemption, the only compelling reason to buy would be diversification or a high yield,” Mousseau said.
At Baa1, BBB, and BBB-plus by Moody’s Investors Service, Standard & Poor’s, and Fitch Ratings, respectively, Puerto Rico would be the lowest rated state, behind California and Illinois.
Alan Schankel, managing director at Janney Capital Markets, said that, all things being equal, Illinois bonds would probably be more attractive to investors than Puerto Rico, without the added tax benefit.
“You’d need a lot more yield to make the Puerto Rico credit, with its inherent credit risk, attractive enough to buy,” he said.
Yields on the commonwealth’s last $2.3 billion general obligation bond sale in March this year ranged from 4.00% with 4% and 5% coupons in 2020 to 5.32% with a 5% coupon in 2041.
Schankel said that if Puerto Rico were to become a state and lose its triple tax-exempt status, it would see its borrowing costs rise.
“The wealth metrics are such that there are not as many theoretical tax-free buyers in Puerto Rico as there are in other states that would need the in-state exemption,” he said. “They would definitely pay more money than they pay today.”
However, he added, it’s possible that as a state, Puerto Rico might not have to borrow as much money because it would have more federal resources, but it’s hard to predict.
“Economically, I think it would be a mixed bag,” Schankel said. “They would get more money from Uncle Sam, they get more Medicaid, but they would also presumably have to pay federal tax, which they don’t pay now.”
While there are many moving parts to becoming a state, Schankel thinks that, overall, the effect on its financial situation would be mildly positive.
In the near term, however, a status change would likely be a credit negative.
“Although a status change could ultimately work in the best interest of debt holders if statehood was approved or be a serious challenge if independence was chosen (highly unlikely) the intervening uncertainty in all but a vote for status quo would be a near-term credit negative,” Schankel
Credit rating agencies have said it is too soon to tell what effect statehood would have on Puerto Rico’s low investment grade credit rating.
However, Karen Krop, senior director of public finance at Fitch Ratings, said that statehood in and of itself would not change Fitch’s BBB-plus rating.
She said that analysts would have to look at any changes, like federal funding, to see if it would affect Puerto Rico’s financial situation.
“We would not change criteria if Puerto Rico becomes a state, since we already use state criteria in rating Puerto Rico,” Krop added.
All depends on the outcome of the status referendum on Nov. 6 when voters in Puerto Rico will decide whether or not they want statehood.
Voters will be asked to answer two questions: whether they want Puerto Rico to continue in its present form of territorial status, and, regardless of the answer to the first question, whether they would prefer statehood, independence, or to be a sovereign free associated state.
While the first two options are self-explanatory, the “sovereign free associated state” would mean a status outside of the territory clause of the U.S. Constitution that recognizes the sovereignty of the people of Puerto Rico.
On Tuesday’s ballot, a description for each option will be provided.
Puerto Rico held similar referendums in 1998, 1993, 1991, and 1967. In 1967, 38.9% voted for statehood, and in 1993 and 1998, 46.4% voted for statehood.
While the vote presents the possibility of a change in the commonwealth’s tax-exempt status, Schankel said that the vote itself would not likely have a significant impact on the municipal bond market.
“I think that the attitude on Puerto Rico bonds would probably be mixed, but I don’t think it would move the market dramatically one way or the other because there are just so many unknowns,” he said.
Actually, the gubernatorial election, scheduled on the same day, might have more impact on Puerto Rico’s bonds than other events.
“I think one of the reasons the spreads have been widening so much lately is concern of the unknown,” Schankel said.
At the beginning of September, yields on Puerto Rico’s GO bonds were 210 basis points above triple-A benchmark yields in 30-year maturities and 235 basis points higher in 10-year maturities.
At the beginning of October, the yields had risen to 220 basis points and 245, respectively. On Oct. 31, they had gone up to 225 and 270 basis points.
Schankel said the spreads are likely tighter on the longer maturities because of concentration of mutual fund and other long duration investor demand.
Analysts and investors watching Puerto Rico have noted that the current administration, under Gov. Luis Fortuno, has been moving the commonwealth’s finances in the right direction.
“In our opinion, the current administration has taken decisive measures to restore fiscal balance,” Standard & Poor’s analyst Horacio Aldrete-Sanchez said in a recent report, though he added that the government’s ability to implement further cuts and revenue enhancements is limited.
Schankel said that Gov. Fortuno has a good track record, noting financial reforms such as the significant reductions in the number of government employees and the narrowing of the government’s persistent budget gap.
“An argument can be made that bond investors will react positively if he is re-elected, but will have a more uncertain view and investment approach if his primary opponent, Alejandro Garcia Padilla, wins the governorship,” he said.
Richard Larkin, director of credit analysis at Herbert J. Sims & Co., wrote in a recent report that the current administration has stuck faithfully to its multi-year plan to attack and reduce deficits, adding that Tuesday’s gubernatorial election will be important for the commonwealth’s future.
“Regardless of which party wins the election, fiscal integrity will be necessary—failure to do so will deepen Puerto Rico’s budgetary and economic challenges to the point where investors should then reconsider their position on investing in the commonwealth of Puerto Rico.”
According to an Oct. 9 poll by El Nuevo Dia, a Spanish-language daily, Padilla led the current governor 41% to 39%.
Fortuño is president of the New Progressive Party, which is generally associated with a “pro-statehood” position. Padilla is president of the Popular Democratic Party, generally associated with a “pro-commonwealth” position.
Regardless of the outcome of Tuesday’s vote, any change in political status would still have to be approved by Congress and the president.
