May 23, 2017
May 23, 2017
Relative to its small economic output, physical size and declining population, Puerto Rico borrowed an awful lot of money the past many years. In part this money was and is used to help provide goods, services and government jobs for inhabitants of America’s most impoverished territory. A good chunk of this money has also been spent to honor generous pension and retiree health care commitments promised to a civil service bureaucracy routinely characterized as “bloated.” In light of these straight-forward realities, you might expect that some day soon Puerto Rico would find itself greatly challenged by the burden of its large debts.
In fact, that day arrived earlier this month when Puerto Rico’s governor, Ricardo Rossello, appealed to U.S. federal courts to protect the territory from lawsuits filed by unpaid and unhappy creditors. The details of Puerto Rico’s effective bankruptcy make for sad and distressing reading but, as with any nasty accident on the side of the road, there is a perverse desire to study the carnage, and perhaps also a sober acknowledgement that we ought drive more carefully. Will the yet to be determined outcome of Puerto Rico’s bankruptcy provide clues as to what might be in store for other U.S. sovereigns that are basket cases, such as our most financially troubled states?
Puerto Rico’s economy has been contracting since 2006, when IRS tax incentives offered to U.S. companies to operate on the island were phased out. It is estimated that roughly 10% of Puerto Ricans have since moved to the U.S. mainland, a classic brain drain that has left the remaining 3.4 million inhabitants (60% of whom don’t have jobs) to foot the bill run up during brighter days. The size of the debt is staggering. In addition to $74 billion of bonded debt, there is an additional $49 billion of unfunded pension liabilities. It takes just a minute to do the math. Add 74 and 49 to get to 123 billion, then divide by 3.4 million, and you get about $35,000 of debt per person.
If distress like this prompts you to rub your hands together and think, “this creates an outstanding opportunity to invest the fixed income portion of my nest egg, so how can I loan more money to the government of Puerto Rico as quickly as possible?” then you are not alone. Some big hedge funds, managed by and for “the smartest guys in the room,” backed up the truck and bought almost one-third of Puerto Rico’s debt – a huge bet. Mutual fund giants Franklin Templeton and Oppenheimer also put a chunk of their municipal bond mutual fund assets in Puerto Rico bonds. (By contrast, Vanguard muni bond funds own virtually zero Puerto Rico debt.)
The immediate appeal of Puerto Rico bonds is fairly simple. Because of the territory’s dodgy finances, yields have long been far higher than those offered by most U.S. states. Moreover, because Puerto Rico is not a state but a territory, the income derived from its bonds is triple tax free for all Americans, exempt from federal, state and local taxes. But as important as the presumed “I will receive high yield” opportunity was the presumed “I can’t lose” legal structure. This is due to the fact that as an unincorporated territory, Puerto Rico has had no legal framework to discharge its debts via a bankruptcy process. Without the ability to rely upon the protection of the courts, creditors assumed that Puerto Rico would have to face the music and slash its budget, downsize its civil service, sell off its beachfront property, and so on and so forth – whatever it might take to fire up some cash. This was how a lot of smart people thought it would go because, after all, rules are rules.
But then they changed the rules. Anticipating a dire situation in which Puerto Rico would have to close not only schools but also hospitals and health clinics, and in a rare outburst of bipartisan cooperation, last year President Obama signed the Puerto Rico Oversight, Management and Economic Stability Act, or PROMESA, a Republican authored bill that allowed Puerto Rico to stop paying its creditors and also negotiate more lenient terms of debt repayment. It failed to lead to the compromise hoped for, however, as the creditors didn’t much budge and few Puerto Rican politicians embraced the kind of widespread austerity that might make it possible for the island to send its scant reserves to hedge funds. In light of this failure and in accordance with PROMESA, Puerto Rico will now ask the court to help negotiate a “responsible” outcome on its behalf, one that it hopes will impose deep losses on its creditors. Interestingly, PROMESA stipulates that the adjudication will not be overseen by a bankruptcy judge but rather by a district court judge (a political appointee) to be selected by the Chief Justice of the U.S. Supreme Court, John Roberts.
Puerto Rico’s creditors and pensioners alike have taken to studying Roberts’ views on municipal debt issues, but the reality is that no one has a clue what his views are nor whom he will appoint to oversee what promises to be a lengthy, contentious process. (Imagine spending the next 18 months sitting across the table from ferocious hedge fund lawyers.) History is not much of a guide in any case. There have been very few municipal bankruptcies, and the settlements implemented by the courts have varied widely depending upon the proclivities of the judge in charge. Perhaps the court will reinforce the rights of creditors and rule that seemingly inviolate pension guarantees can in fact be changed. Alternatively, perhaps the court will look skeptically at the hedge funds and other deep pocketed players and prefer to protect the interests of aged retirees. What might you do? Would you read the law carefully (such as it is) without regard to the respective parties’ ability to absorb a loss?
If PROMESA allows Puerto Rico to discharge enough of its debts such that it can re-enter capital markets, some wonder if perhaps the federal courts can eventually be used to allow U.S. state governments to seek debt relief as well. This is currently prohibited, since state governments, as sovereigns, are not included in Chapter 9 of the U.S. bankruptcy code and thus cannot receive bankruptcy protections. Here, too, opinions as to whether wobbly states must eventually be allowed to wriggle out from under their debts vary widely. Can Congress simply change the rules of the game so as to rescue, say, Illinois and Connecticut, states from which taxpayers are already fleeing? (Taxpayers are leaving California, too.) Will the inhabitants of prudent states be forced to pick up the tab for the imprudent? If pensions are said to be protected by many states’ constitutions, how sturdy might such protections be if these same states find themselves seeking relief in federal courts?
We believe that the situation in Puerto Rico serves as a reminder that prudent municipal bond investors are wise to prefer high-quality paper. High yields are always tempting, but because all entities borrow money at the lowest rates they can find, high yields effectively announce comparably high risk. At times of crisis, fixed income investors are rightly focused on the return of their capital. Return on capital is of decidedly secondary importance.