As of late, Puerto Rico has been in the news due to financial problems that stem from too much debt, a shrinking population and weak economic growth. Consequently, Puerto Rico's debt has now been downgraded to below investment-grade status. Puerto Rico is a territory of the United States and as a result is able to issue municipal debt that is federal and state tax-free to investors in every state. Puerto Rico has roughly $70 billion in outstanding debt that is widely owned by municipal bond investors in high-tax states with limited municipal bond supply due to Puerto Rico’s favorable tax treatment and ample supply.
The government of Puerto Rico has been taking steps to stabilize their economy. Governor Alejandro Garcia Padilla has enacted drastic pension reform and economic growth has improved recently. However, Puerto Rico needs to access the bond market next month with a planned $3 billion dollar bond sale. In order to attract investors, Puerto Rico will have to pay a high single-digit rate of interest in order to compensate investors for the default risk. We believe that Puerto Rico will be able to successfully issue this debt which should shore up the finances as well as lessen the news flow. Additional liquidity coupled with less financial media attention should allow for a rebound in the prices of the debt.
While the situation in Puerto Rico appears to have stabilized, the territory is not yet out of the woods. There are still high levels of unemployment and violent crime and a business climate that is considered to be unfriendly. If the financial situation gets worse, there is some question whether the U.S. Government would step in to provide assistance. This is a complicated situation in that Puerto Rico is a territory and not a state. Detroit was allowed to go bankrupt and received no state or Federal assistance. In addition, there is not a clear mechanism for an orderly bankruptcy due to the territory status.
If the situation in Puerto Rico becomes more serious, some are concerned that it would become a systemic crisis across the municipal bond market. In past municipal bond market corrections, we have used the dislocation to buy bonds at attractive valuations for our clients. Overall, municipal bonds have been a very safe investment, specifically according to Moody's for the last 40+ years, only .012 percent of municipal bonds have defaulted. Said differently, Strategas Research has calculated that of the greater than 1 million municipal bond issues outstanding only 71 have defaulted between the years of 1970 and 2011.
Our takeaways for the week:
- We have not actively purchased Puerto Rico debt for our clients in the past and are not buyers at this time. We view Puerto Rico debt as a “hold” for investors that do own the debt. Presently, the situation is characterized by more smoke than fire. Following a successful bond offering and as news flow abates, there will probably better opportunities to exit positions in Puerto Rico debt if individual risk preferences warrant doing so.
- This week we saw the S&P 500 hit new all-time highs.