Opinion: Do Puerto Rico muni bonds belong in your portfolio?

The investment is risky, but a potential payoff is there for sophistical investors

A street in Old San Juan, Puerto Rico

A street in Old San Juan, Puerto Rico

ByJOHN COUMARIANOS

Star bond manager Jeffrey Gundlach remarked on a recent conference call that he had just bought some Puerto Rico municipal bonds priced at 65 cents on the dollar for his personal portfolio.

Should individual investors follow Gundlach in seeking what he said could be a 12% after-tax return?

To answer that, investors need to understand the risks, and a discussion of the economic and political backdrop can help.

Rust Belt in the Caribbean
Puerto Rico owes about $72 billion, mostly in the form of municipal bonds. By many accounts, including that of Puerto Rico Gov. Alejandro Garcia Padilla, the island territory of the U.S. will not be able to pay all of its debts. Around 30% of Puerto Rico’s revenues go toward debt service, far and away above any U.S. state.

According to reporter David Dayen, Padilla has cited the phase out of Section 936, providing industrial subsidies to Puerto Rico, in 1996 as the beginning of the island’s troubles.

It’s likely that NAFTA and the migration of manufacturing to Asia, especially by giving China most-favored-nation status, hurt Puerto Rico’s manufacturing base too.

In other words, the story of Puerto Rico over the past two decades is the story of America’s Rust Belt. Industry has vanished from Puerto Rico, arguably making the island at least partly a victim rather than sole engineer of its problems.

In order to maintain services in the face of declining gross domestic product, the island resorted to borrowing. As a U.S. territory, Puerto Rico’s bonds, along with those of Guam, American Samoa, and the U.S. Virgin Islands, have triple tax-free status.

In other words, any American who owns Puerto Rico bonds pays no federal, state, or local tax on the interest they pay, which, of course, meant Puerto Rico was able to borrow cheaply before investors doubted its creditworthiness.

Political malfeasance
But this ability to borrow easily combined with political malfeasance to crash Puerto Rico’s finances. Puerto Rico’s predicament stems from its decision to address social welfare problems in “an incredibly inefficient way,” according to political scientist Daniel DiSalvo. Puerto Rico built a massive public sector that now employs 1 in 4 people in the territory.

Also, Puerto Rico’s peculiar political status as a territory has contributed to its troubles.

Puerto Rico’s parties are more organized on whether Puerto Rico should become the 51st state rather than on liberal-conservative lines. This, according to DiSalvo, “reduces ideological coherence, transparency, and accountability.”

The lack of accountability, in turn, means both major parties have used the government-owned corporations as vehicles to subsidize other industries or make income transfers. Hotels, for example, didn’t pay electric bills at times.

Now that the bill is due, utilities have hiked prices, and consumers have fewer dollars to spend, contributing to Puerto Rico’s decade-long recession. The labor force has declined, and outmigration of the middle class is prevalent.

At this point, the U.S. Congress can arrange a structured bankruptcy, or Puerto Rico can default without congressional action. The latter scenario could lead to years of litigation, and could destabilize the municipal bond market.

May 1 deadline
A debt payment of $422 million is due on May 1 on bonds issued by the Government Development Bank that plays a critical role in Puerto Rico’s finances. A gaggle of politically well-connected distressed debt hedge funds that own Puerto Rico bonds issued by the bank asked the federal court in San Juan to freeze the bank’s assets in early April.

For its part, Puerto Rico’s government wants to declare bankruptcy, forcing creditors to take losses. However, bankruptcy law excludes Puerto Rico from “Chapter 9,” the statute governing municipal and state bankruptcies. According to a recent New York Times piece, nobody can give a clear answer why Puerto Rico is excluded.

Puerto Rico has, in fact, already defaulted on $221 million of debt, prompting lawsuits from creditors, including two mutual fund companies, Franklin Advisers and Oppenheimer Funds. So far, the U.S. District Court in San Juan and the Court of Appeals for the First Circuit have agreed with the fund companies.

After its $422 million May payment, Puerto Rico has another $2 billion coming due in July in debt issued by the central government and large government enterprises such as the electric power authority, the water and sewer authority.

The scramble
According to another Times piece, legislation was introduced by Democrats in the House of Representatives on April 12 to try to help Puerto Rico without entering the territory into Chapter 9.

The bill avoided the harshness of an earlier proposal for an oversight committee in Washington that could impose taxes and control expenses, but at which Puerto Rico bristled as colonialist, degrading and undemocratic. However, the bill gives Puerto Rico the ability to restructure some of its debt, making opponents call it Chapter 9 by another name.

According to a Bloomberg piece, Puerto Rico has said it would pay 74 cents on the dollar for general-obligation and government-guaranteed debt and 57 cents for sales-tax securities. The commonwealth’s general obligation bonds enjoy constitutional protection, though it’s unclear whether any managed outcome would respect that or whether it would treat the GO bonds similarly to bonds issued by the 17 other entities on the island.

The investment thesis
It’s difficult to perform an economic analysis of Puerto Rico’s municipal bonds. Investors wading in must forecast the results of some kind of politically mandated restructuring.

Investors must also treat any investment in Puerto Rico debt as part of their risk assets rather than as part of their bond portfolios.

In an interview with MarketWatch, Puerto Rico bond expert Cate Long said a position in Puerto Rico’s debt was reasonable for a sophisticated investor who treated it as if were a risky individual stock. She also encouraged investors to consult the Electronic Municipal Market Access (EMMA) website established by the Municipal Securities Rulemaking Board (MSRB) for pricing and general information.

No investor should treat Puerto Rico municipal bonds as bonds. But given that Puerto Rico has indicated it would pay 74 cents on the dollar toward its GO bonds (they are at around 60 as of this writing), there’s reason to think investors treating Puerto Rico munis as a stock position have an interesting risk/reward profile below that.

Los comentarios para este artículo han sido cerrados.