Puerto Rico’s turbulent debt restructuring process is sending ripple effects through the market for other triple tax-exempt bonds issued by U.S. territories, causing rating agencies and investors alike to look with increasing skepticism at another U.S. territory with a heavy debt load: Guam.
The Pacific island territory with a population of about 163,000 has about $1.3 billion of debt, including $768 million of bonds secured by the business privilege taxes, $237 million of bonds secured by customs fees and transfers of federal income tax revenues, and $181 million of certificates of participation issued for school projects. While rating agencies and investors have for several years been mindful of Puerto Rico’s financial troubles when thinking about Guam and other territories, there is evidence that the increasingly messy Puerto Rico situation is creating more skepticism.
David Tawil, president of New York-based hedge fund Maglan Capital, said that the heightened awareness created by Puerto Rico’s fiscal distress and recovery process and shaken investor confidence stemming from the Puerto Rico debacle could blow back on Guam.
“In light of the chaotic and unfortunate situation in Puerto Rico, I think that Guam is receiving heightened scrutiny from the rating agencies,” Tawil said. “Furthermore, the government’s pledge to prioritize the service of debt is no longer as comforting as that type of statement once was, in light of the fact that Puerto Rico officials said the same prior to its default.”
The debt of U.S. territories is triple tax-exempt, meaning interest isn't subject to federal, state or local income tax. That tax-free status, combined with generally high yield, has been historically attractive to investors.
Both Moody’s Investors Service and S&P Global Ratings have taken action on Guam in recent weeks that reflected new financial woes. S&P placed the island’s already junk-rated debt -- BB-minus for general obligation bonds and B-plus for certificates of participation -- on credit watch negative, while Moody’s affirmed Guam’s Ba1 rating but assigned a negative outlook to rated Guam debt, including revenue bonds of the A.B. Won Pat Guam International Airport Authority, Guam Power Authority and Guam Waterworks Authority. Both agencies cited revenue shortfalls stemming from the enactment of the federal tax reform bill.
Guam's tax rates mirror federal law and the new federal rates meant an abrupt revenue shortfall for the territory.
“The most recent estimate is that revenues for the current fiscal year, 2018, will fall short of budget by approximately $67 million or 9.7% of budgeted general fund revenues,” Moody’s said March 14. “While the government has enacted some spending cuts to offset the shortfall, it has not yet adopted tax increases needed to close the budget gap completely. Moreover, as tax withholdings have come in short of budgeted amounts, the government’s liquidity has deteriorated rapidly.”
Guam has responded with some austerity measures, passing legislation just days after the rating agency actions to implement a new sales tax and temporarily increase the business privilege tax by 25% beginning Oct. 1. Gov. Eddie Baza Calvo said in a statement that the legislation was a relief, but warned that Guam is still going to have to weather some tough times ahead.
“After months of debate and sharing information, we finally have a road map and something to help us bridge the $67 million shortfall caused by changes in the federal tax policy,” Calvo said. “I want to thank the Senators who understood the gravity of the situation we face because contrary to what some people have said, and continue to say, this situation was not fabricated. It is a true fiscal crisis created not by any decisions on Guam but by a legislative body 8,000 miles away in Washington D. C.”
Calvo said he anticipated further meetings with members of Guam's 15-member legislature to discuss reorganization of the government to make it “streamlined and more efficient.”
“Unfortunately, the crisis isn’t over,” the governor continued. “In fact, we still have some tough times ahead of us. My team and I already have volunteered a 32-hour work week and I anticipate that this will last for the next month or so, at the very least.”
While the new federal tax policy created an acute local financial crisis for Guam, it is far from the only source of rating agency and investor concern for the island’s long-term repayment plans.
Puerto Rico is 9,400 miles from Guam, but its messy bankruptcy proceedings are providing a road map for how a similar situation might play out in another U.S. territory.
“To date, Puerto Rico’s bankruptcy has been turbulent, and we believe future events should prove to be equally unsettled,” RBC Capital Markets said in a piece published this month that noted that the aggregate bondholder recovery under the current Puerto Rico fiscal plan is 17%. “The commonwealth’s draconian posture and fiscal obfuscation discourages compromise, instead emboldening creditors to wait until after the plan of adjustment is released to litigate their rights. Unfortunately, we predict the plan will not be released for at least another year.”
The U.S. Congress passed a special law, the Puerto Rico Oversight, Management, and Economic Stability Act in 2016, to create a restructuring process for the most populous U.S. territory. Recent developments in that restructuring process have not given investors any warm feelings. In particular, federal bankruptcy judge Laura Taylor Swain recently ruled that she is not authorized under PROMESA to interfere with Puerto Rico’s properties and revenues, a ruling that bond insurers on the hook for part of Puerto Rico's debt have said they are planning to appeal.
Guam's financial troubles are long-standing.
"Guam has a history of structural imbalance in its general fund, including recurring deficits, a very large negative general fund balance, and massive long-term liabilities," S&P wrote March 5 when it placed the territory's debt on watch negative.
“The worst part of this is that it might be a vicious cycle and a self-fulfilling prophecy,” said Tawil. “In other words, Puerto Rico may not be able to return to the normal capital markets any time in the near future because of its default and the resulting questionability of debt-obligation enforcement and recovery to bondholders. Due to that uncertainty, rating agencies will now view Guam’s similar circumstances conservatively and skeptically. That will lead to municipal investors distancing themselves from the commonwealth.”