It's a U.S. Caribbean territory with economic problems, high levels of pension and bond debt, and a track record of deficit financing.
But the U.S. Virgin Islands have not attracted the municipal bond market's attention in the same way as has Puerto Rico, its larger neighbor 40 miles to the west.
Where purchasers on the secondary market in this past year have asked for asked for spreads of 400 to 600 or more basis points to the triple-A benchmark for Puerto Rico munis, Virgin Islands bonds have commanded much lower premiums.
For example, the Virgin Islands Public Finance Authority sold triple-B revenue refunding bonds in November 2012 with a 10 year maturity at 3.34%, 177 basis points over the Municipal Market Data AAA benchmark at the time. On Jan. 27, the most recent trade over $1 million, the bonds sold at 3.36%, just 126 basis points over the AAA benchmark.
In December 2012 the authority sold triple-B gross receipts tax bonds with a 30 year maturity at 5.28%, 242 basis points over the benchmark at the time. On Dec. 3, 2013, the most recent trade over $1 million, the bonds sold at 5.42%, just 129 basis points over the AAA benchmark.
Though Puerto Rico and the Virgin Islands share some important characteristics, notably across-the-board exemption from state and federal income tax on bond interest, there are substantial differences.
The Virgin Islands' population and economy are orders of magnitudes smaller than Puerto Rico's; the Virgin Islands have about 105,000 residents, compared to more than 3.6 million in Puerto Rico.
Unlike Puerto Rico, the Virgin Islands have no outstanding general obligation debt. Instead, their bonds either come in the form of the matching fund (also known as revenue refunding) bonds mentioned above or gross receipts tax bonds. The senior lien of the former are rated BBB by Fitch Ratings, BBB by Standard & Poor's, and Baa2 by Moody's Investor's service. The senior lien of the latter are rated BBB by Fitch Ratings.
The Virgin Islands Water and Power Authority also issues bonds that the ratings agencies rate a bit lower.
Fitch senior director Marcy Block described the Virgin Islands' debt level as "extremely high." Tax supported debt as of Oct. 1, 2013 was 77% of personal income. This compares to 75% for Puerto Rico, also according to Fitch. Of course, in absolute terms it is much smaller, with Fitch saying it is $2 billion compared to $47 billion for Puerto Rico.
The Virgin Islands have $1.74 billion in debt, according to Virgin Islands commissioner of finance Ángel Dawson.
The Virgin Islands also have an underfunded pension plan, with a funding ratio around 50% as of Sept. 30, 2011, according to Block. The $1.7 billion unfunded liability is equal to about 60% of estimated 2012 personal income.
In response to Fitch's concerns about the debt, Dawson said the islands' debt structure was conservative with declining debt service in the future. Both of the islands' bond types have debt service coverage ratios of 2.5 to 3.5 times on the senior liens.
"Approximately 60% of our bonds are secured by the federal cover over [rum tax] revenues rather than a locally collected source derived from local economic activity," Dawson said. "Therefore, the aggregate level of indebtedness constitutes a significantly smaller drag on the local economy than the aggregate debt ratio might suggest."
As for the pension liabilities, a task force has recently recommended increased employee contributions, elimination of cost of living increases and a reduction in benefit levels for both workers and retirees, Dawson said. These proposals have recently been submitted to the legislature for consideration.
Adding to the Virgin Islands' difficulties, it has had a weak economy since 2008. The initial contraction on the island was related to the general world recession. Unemployment was around 8% to 9% to 2011 from 2008, Dawson said.
In early 2012 the Virgin Islands' largest employer, the Hovensa oil refinery, closed, costing 2,000 workers their jobs. The difference between the 7.6% unemployment rate in 2009 and December 2013's 13.0% rate is 2,700 lost jobs, Dawson said. This shows how important the refinery was, he said.
According to the U.S. Bureau of Economic Analysis, the U.S. Virgin Islands' real gross domestic product decreased 13.2% in 2012 after decreasing 6.6% in 2011. If data related to the refinery were excluded, GDP would have increased 2.6% in 2012.
While the islands' government is trying to sell the refinery property to another refiner, Fitch believes it will have a difficult time finding a buyer, Block said.
Dawson said the government is optimistic about selling the refinery.
Tourism is the leading sector in the Virgin Islands economy, with about 25% of jobs connected to it, Dawson said. By comparison, the sector accounts for about 8% of Puerto Rico's economy. Block and Moody's Analytics associate economist Abraham Goldstein expect tourism will improve in the next few years. However, hotel occupancy was at just 48% in 2012 because most visitors are from cruise ships, Block said.
Rum manufacturing at two distilleries is also important to the economy. While the Cruzan distillery has produced rum since 1946, the Diageo distillery only started shipping its rum in 2012.
Both distilleries are important to the islands' bondholders because the rum they sell in the mainland United States provides the revenue stream servicing matching fund bonds. For more than 50 years the U.S. Congress has approved a tax on rum from Puerto Rico and the Virgin Islands sold in the mainland, with the revenues sent back to the territorial governments. The Virgin Islands uses this revenue stream to pay off the matching fund bonds. It also diverts some of the revenue stream to the distillers, under agreements with them.
The Diageo facility is ramping up production, Goldstein said.
To diversify and strengthen the economy, Dawson said the Virgin Islands government streamlined business regulation and utilized the American Recovery and Reinvestment Act of 2009 to construct a territory wide high speed Internet system.
Yet Block and Goldstein are fairly pessimistic about the Virgin Island's economic future. "In the long run, growth will lag that of the U.S., as poor industrial diversity, low incomes, out-migration, and high business costs will hold the territory back," Goldstein said.
The weak economy of the last six years has contributed to the government running operating deficits.
In response since 2009 the government has been reducing its workforce, Dawson said, and its total size is down 23% to the end of December 2013 compared to March 2009. By early 2012 the government was approaching a balanced budget when Hovensa closed. This reduced government revenue by $100 million, or more than 10%.
The government plans to use bonds to cover just 3% of its expenditures this fiscal year, Dawson said. Its use of bonds for this purpose is just 10% of what it had used three years ago, he said.
Dawson said the government plans to use no bond funding for deficits in the next fiscal year. However, Block said she expected continued budget imbalance over the next few years.
Block and Goldstein are also fairly pessimistic about the economy.
The U.S. Congress has let a higher tax rate on imported rum lapse at the start of 2014, at least temporarily. Since these taxes are partly diverted to cover the Virgin Islands matching funds bonds, this is a negative for bond holders.
Block said the Congress may retroactively increase the rum tax but it was unclear whether this would happen. Dawson said he expected the retroactive increase but that his government continues to run scenarios using the lower rate.
Dawson noted that for the first time in at least 20 years the government is up to date on releasing its audited financial statements. He said that the government expects its next bond to be a $77 million federal highway grant anticipation revenue bond to be sold sometime from April to June this year.
