U.S. District Judge Laura Swain in January confirmed Puerto Rico’s plan of adjustment. The confirmation is the capstone for Puerto Rico’s journey through a new territorial bankruptcy law called PROMESA, and it comes more than six years after the island’s former governor, Alejandro Garcia Padilla, declared the commonwealth’s debts not payable.
The confirmation paves the way for a debt exchange that will bring new Puerto Rico bonds to market. The commonwealth’s bonds were long prized by muni investors because the interest is exempt from federal, state, and local taxes for holders throughout the U.S., and because yields have traditionally been higher than most U.S. munis due to elevated perceived risk.
The painful bankruptcy experience – by far the largest ever in the muni-bond market in terms of the amount of debt affected – may cause some investors to shun the next wave of Puerto Rico issuance. Yet we believe there may be cause to look at the commonwealth’s debt with fresh eyes. Post-bankruptcy credit quality usually improves for muni issuance, with new bonds offering enhanced security and other favorable provisions for investors.
Rebuilding and restructuring
The journey since PROMESA was signed into law by President Barack Obama in 2016 has been complicated by two major hurricanes in 2017 and a global pandemic that restricted travel to an island that has been planning on expanding tourism. Those tragedies ushered in a wave of fiscal support (estimated at about $130 billion, or over 100% of Puerto Rico’s GDP), facilitating an ongoing recovery and rebuilding that will aid the island’s tax collections and economy for years to come.
By 15 March, we expect that about $35 billion of Puerto Rico’s debt and claims will be exchanged into a mix of cash and new debt, including a contingent convertible instrument that is payable to investors if sales tax collections outperform a benchmark in the certified fiscal plan.
The exchange follows prior successful exchanges for the Puerto Rico Sales Tax Financing Corporation (COFINA) and the Government Development Bank (GDB). We anticipate that these various debt proposals in aggregate will likely reduce the stock of Puerto Rico’s debt by about 50%, and that average debt service on government guaranteed obligations will fall by about 60%.
Financial and technical strength
Restructured muni debt has typically outperformed the broader muni market, as issuers emerge from bankruptcy with higher debt-servicing capacity and the debt re-enters the municipal high yield index.
Issuers exiting bankruptcy typically offer excess yield premiums to account for a lack of credit ratings and a more limited pool of buyers. Simultaneously, the security structure oftentimes improves and provides stronger security for bondholders, with leverage reduced as a result of haircuts imposed on legacy debt owners. In the case of Puerto Rico, a new debt-management policy shall cap annual debt service on all net tax-supported debt at 7.94% of the prior year’s internally generated general fund revenues, according to the plan of adjustment.
Numerous commonwealth issuing entities fit this description. One example is Puerto Rico’s COFINA sales tax bonds, which were restructured in 2019. The new bonds are backed by a legal lien authorized by a federal bankruptcy court judge, and they have since outperformed the broader high yield muni index (see Figure 1). Recently, Puerto Rico signaled its intent to refund the newly restructured sales tax bonds. We expect commonwealth bonds issued by other entities, such as general obligation bonds, will follow a similar pattern in the near term.
Figure 1: Restructured COFINA bonds have outperformed high yield muni market
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New Puerto Rico bonds created by the completion of bankruptcy proceedings will be eligible for high yield muni indices. Municipal high yield mutual funds tracking high yield muni indices may reposition into Puerto Rico debt, and trading desks may begin to trade the contingent convertible instrument. Prior to bankruptcy, Puerto Rico debt accounted for about 20% of the high yield muni index, and forced buying would be a tailwind for bondholders.
Additionally, Puerto Rico may again see its debt rated by the credit-rating companies in the future, which could make it more appealing to a greater number of investors. Puerto Rico’s triple tax exemption can be particularly appealing to investors in high-tax states, such as California and New York.
Eventually the technical allure of Puerto Rico debt should settle, and the market will assess Puerto Rico’s future prospects and overall creditworthiness. Questions are already arising about whether the financial oversight board put in place by PROMESA succeeded in implementing sufficient reforms to maintain long-term solvency, and whether Puerto Rico will have the continued willingness to honor future obligations to creditors, and to adhere to structural reforms, once the oversight board disbands.
The amended fiscal plan envisions deficits returning in 2049 after the effects of fiscal support fade, and projects that Puerto Rico’s population may decline by 25% by 2051. In the meantime, the municipal high yield market appears ready to welcome back a familiar face with open arms.
David Hammer is a managing director in the Newport Beach office and head of municipal bond portfolio management. Sean McCarthy is head of municipal high yield credit research at PIMCO.
* References to specific securities and their issuers are not intended and should not be interpreted as recommendations to purchase, sell or hold such securities. PIMCO products and strategies may or may not include the securities referenced and, if such securities are included, no representation is being made that such securities will continue to be included. It is not possible to invest directly in an unmanaged index.
DISCLOSURES
All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Income from municipal bonds is exempt from federal income tax and may be subject to state and local taxes and at times the alternative minimum tax; a strategy concentrating in a single or limited number of states (or territories) is subject to greater risk of adverse economic conditions and regulatory changes.
Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.
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CMR2022-0219-2047622
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