As close followers of the municipal credit asset class, we have identified three helpful indicators since fiscal year 2009–2010, the year the financial crisis harshly impacted state and local government finances. They are:
- Changes in property values pre-date ad valorem tax revenues and fiscal balances for state and local governments by anywhere from 12–18 months.
- Sales tax revenues adjusted for changes in tax rates are the best coincident indicator we know of for measuring final demand in an economy.
- State and local governments can easily restructure their balance sheets without skipping payments to bondholders. They willfully reprioritize their payments simply by cutting aid to schools, taking pension holidays, and neglecting much-needed infrastructure investment, all positives from a creditor’s perspective.
In meetings in front of strategists, economists, insurance companies, and bankers around the country, we have made the bullish case for insured Puerto Rico debt. We summarized our views on our website in a piece published October 5th, titled “Puerto Rico: A Story You Probably Haven’t Heard.”
The latest and greatest out of Puerto Rico is a draft bill put forth by the Obama Administration that will give Puerto Rico and other territories access to a new series of Chapter 9 Bankruptcy provisions. This is a new step forward in the Federal government’s involvement in the Puerto Rico saga. Prior to now, involvement has been done via executive order without new budgetary authorization from congress. For example, the revamping of P.R. Act 154 allowing U.S. companies to write-off a tax credit equal to the amount of taxes they pay to the Puerto Rican government against their U.S. federal returns (we write about this in our piece “More on Puerto Rico Debt,” published last year); and various other acts allowing Puerto Rico-domiciled investment firms to avoid taxation on passive income. Nonetheless, this creates interesting conversation about the U.S. federal government’s role in Puerto Rico, and we have definitely felt a negative market reaction. We summarize our thoughts on this below.
- We place the odds of this bill becoming law at 50%. The odds of this bill becoming law in its current form are close to zero. Direct engagement by U.S. Treasury in the affairs of states, aside from nondiscretionary entitlements like Medicaid, is close to zero. Boehner will likely not take this up prior to leaving his speakership. In an environment where President Obama and congress cannot pass a clean debt ceiling extension without adding bells and whistles, this bill will likely face resistance from certain groups in the House such as the Freedom Caucus. Hearings and final passage of a law will likely be a protracted process.
- The law, apart from structural changes to U.S. Bankruptcy Code, which are budget-neutral, contains expansion of means-tested programs such as the earned-income tax credit and Tax Assistance for Needy Families. These provisions seem unrelated to the task at hand, which is the appointment of a Federal Judge to oversee the restructuring process. With Puerto Rico’s status as a Commonwealth, we are in uncharted territory.
- A Chapter 9 Bankruptcy applicable to Puerto Rico, or the threat thereof may serve as a deterrent to hold-outs on both sides of the table, forcing negotiations, instead of wresting control into the hands of a 3rd party. This would expedite the process.
- Lawyers, consultants, accountants, and restructuring experts will make-out well in the end, regardless of the outcome.
The initial intent of this piece was to discuss the Puerto Rican economy’s growth path.
Puerto Rico’s economy has been improving. And now, yet another statistic indicates that. On October 21st, the United States Bureau of Labor Statistics reported that total employment on the island pierced the one million mark, up 2.27% from the level a year ago. The unemployment rate has declined; labor force participation is stable; and total nonfarm employment continues to increase. By most measures, our first forward-looking indicator (mentioned in the first sentence of this piece) is accurately predicting Puerto Rico’s return to fiscal stability.
Another tidbit: it is difficult not to find a news headline with the words Puerto Rico and restructuring in the same sentence. But who says Puerto Rico hasn’t restructured its expenses? General government expenses are down 35% from levels two years ago, and the government has been able to increase its working capital by deferring its average payment period on accounts payables from 47 days to 80 days. Puerto Rico is flexible. There are other signs of Puerto Rico’s restoration to a positive fiscal balance. We discuss these themes in our top-selling book, Adventures in Muniland: A Guide to Municipal Bond Investing in the Post-Crisis Era.
We do not recommend purchase of uninsured Puerto Rico debt. Our meetings with senior-level management at National Public Finance Guarantee and Assured Guaranty last week have reinforced our favorable outlook on these two bond insurers and their claims-paying ability. Since its first insurance policy was written 30 years ago, National Public Finance Guarantee (formerly the Municipal Bond Insurance Association, or MBIA) has paid out roughly $700 million in claims. It currently has $4.9 billion in claims-paying resources and loss experience in the low single-digit basis points in its insured portfolio over the last 30 years. Assured Guaranty is in a similar positive position. We believe it is important to couple the insurance wrapper with the underlying Puerto Rico bond structure when determining which bond to buy and which one to avoid.
Finding insured AA paper at yields approximating 5.75–6% tax-free is not an easy task. Cumberland is a buy-side, fee-for-service-only manager, able to manage complex portfolios and source bonds from its large network of dealers at low transaction cost for its clients.
There are opportunities elsewhere in munis, too. Stay tuned.