Puerto Rico Gets The Cold Shoulder

Last week was a difficult one for the Commonwealth of Puerto Rico.

On Wednesday and Thursday, the governor and legislature passed a law creating a statutory framework for the Commonwealth’s public corporations to restructure their debt and contractual obligations. This legislation is analogous to US Chapter 9 laws and dispels prior notions held by market participants that the Commonwealth would come to the rescue to bail out its public corporations. It appears that the ratings agencies were caught off guard by these changes as well and downgraded the Commonwealth’s public corporations (in some cases multiple notches) as a result.

In years past, the demarcation points between what constituted GO vs. agency debt was blurred. Ratings agencies and the marketplace treated Puerto Rico GOs and enterprise debt as being on parity with each other and assigned a slightly better value to the enterprise debt, given its “double-barrel” appropriation-backed and enterprise revenue pledge. The government’s recent shifting stance marks a “sea change” in how it views its corporations. No longer will they be treated as within-arms-length conduits acting on behalf of the Commonwealth; instead they will function as independent enterprises, with more autonomy. The current governor, Alejandro Garcia Padilla, ran in 2012 on a mandate to turn the public corporations into enterprises independent from the Commonwealth.

Governor Padilla introduced the Recovery Act to preempt what he sees as an inevitability at this point: restructurings of public corporations and possible forbearance agreements. The sudden shift in stance, which comes at the expense of bondholders, ignores an institutional framework that has been in place for the past 60 years. The governor’s tactics in reneging on what was effectively an unspoken agreement between bondholders and the Commonwealth obscures the fact that the prior actions of the Commonwealth, using public corporations as conduits for debt issuance, are what got us here in the first place. Investors have now been given the cold shoulder.”

We note the following characteristics of Puerto Rico debt as evidence of the “within arms-length” relationship that has existed between the Commonwealth and its corporations:

1. Bonds of the Puerto Rico Highways and Transportation Authority (PRHTA), and other public corporations are secured by revenues of their various enterprises but subject to prior claims from the Commonwealth’s GO bondholders. This “constitutional clawback” allows the Commonwealth to dip into revenues to repay its general-obligation indebtedness.

2. Annual operating subsidies are granted to Puerto Rico Aqueduct and Sewer Authority equal to 10% of revenues; subsidies are granted to Puerto Rico Electric Power Authority (PREPA); and the corporations are required to make offsetting payments back to the Commonwealth in lieu of taxes.

3. Low collections rates and high receivables balances from the Commonwealth (by far PREPA’s largest customer) for services rendered to it by public corporations would not occur under normal arms-length business transactions. PREPA’s accounts receivables balance from the government sector hovers around $400 million, equal to 8-10% of revenues.

4. Prior to 6/27/14, Moody’s had rated Puerto Rico Electric Power Authority (PREPA) as equal to or better than the Commonwealth’s GO credit quality. The same does not hold true for PRASA, but buyers may have lumped those two together as being similar. The notching differential by Moody’s where PREPA is rated lower than the Commonwealth is a new phenomenon that has occurred as a result of Moodys’ view of the “de-linking,” in their own words, between the Commonwealth and PREPA and the public corporations.

5. The following excerpt, taken from a Moody’s report dated 2/6/2012 for a PRASA new issue, highlighted the fact that a PRASA bond was issued to finance the Commonwealth’s own budget deficit:

Proceeds of the … bonds will be used for refinancing $1.1 billion in lines of credit that had been extended by the [Government Development Bank] GDB and a $241 million bond anticipation note that was issued to repay a syndicated loan maturing in January 2012.… Furthermore, given the historical level of support from the commonwealth, Moody's views this financing as essentially a deficit financing of the commonwealth.

The law also opens up a broad discussion regarding the legal apparatus in place in Puerto Rico, which most closely resembles Swiss cheese. Since the US took control of the island in 1901, there have been efforts to “recodify” or “harmonize” the Commonwealth’s government, based in Spanish civil code, with the US legal system. True reforms have been slow to come, but a large step in the process was last Wednesday’s passage of this new act which, quoting from a press release, will allow such public corporations to “overcome their financial obstacles, through a statutory process that allows them to handle their debts fairly and equitably, while ensuring the continuity of essential service and infrastructure upgrades.” This is no doubt a page out of US Chapter 9 Bankruptcy Code, which also stipulates a “fair and equitable” settlement under a bankruptcy.

Going forward, we believe in the need for purchasing credit-enhanced paper when buying Puerto Rico public corporation debt. The market is currently pricing insured paper at around 5.25%, whereas uninsured paper across the curve is trading on a recovery value of $44-47. Yields on insured versus uninsured paper have diverged in the past few months on questions of the credit erosion of the public corporations and upgrades of AGM and Natl-RE by Moody’s and S&P (when monolines insure a bond they are effectively selling their rating, the value of which increases as the rating increases). Other Puerto Rico debt, such as GOs and sales tax bonds, have traded higher in price since the restructuring legislation announcement, as they are specifically addressed as not being able to be restructured under this law. They will likely be kept intact to allow for future financing needs. We do not own uninsured paper issued by the Commonwealth’s public corporations, as the risk of restructuring has increased substantially since last week.

In the coming days, weeks, and months, we expect new developments to occur which will create more of a divergence between Puerto Rico GO debt and bonds issued by PREPA, PRASA, and PRHTA. As obligations from these entities comprise roughly 40% of total public debt outstanding in the Commonwealth, the governor has found a convenient way to reduce the island’s debt burden without an ugly sovereign restructuring. Other steps will have to be taken to reduce the island’s energy costs and regain competitiveness, but this is likely the first of many steps to be taken in deleveraging and reducing the government’s footprint in the economy.


Michael Comes, CFA, Portfolio Manager & Vice President Research