PIMCO’s Outlook: Puerto Rico’s Debt Crisis

Puerto Rico’s Debt Crisis by Joseph Deane, David Hammer, Sean McCarthy, PIMCO

Puerto Rico’s municipal debt has been mired in negative news headlines and heightened price volatility. Joe Deane, head of municipal bond portfolio management, Dave Hammer, municipal portfolio manager, and Sean McCarthy, head of municipal credit research, recently discussed the evolving situation and how it affects PIMCO’s muni market outlook and portfolio positioning.

Q: Over two years ago, PIMCO implemented a 0% allocation to Puerto Rico’s municipal bonded debt across our dedicated municipal portfolios, a major statement given the amount of the island’s debt outstanding. What led to that decision?

Deane: We have long viewed the challenge facing Puerto Rico (PR) as a debt sustainability issue. This led us to sell the last position in PR debt in our dedicated municipal portfolios in the first quarter of 2013 at a premium dollar price. And today, firmwide, we maintain zero exposure to Puerto Rico credit risk. PIMCO’s rigorous top-down, bottom-up investment process confirmed our suspicions and informed our decision. Our credit research team’s analysis of PR’s capital structure has been extensive and exhaustive. When we weighed the economic, demographic, political and financial makeup of the island against the sheer amount of liabilities outstanding – $73 billion of bonded debt and around $30 billion of unfunded pension liabilities – it led us to conclude that the Commonwealth would face significant challenges making creditors whole on those obligations.

Q: Puerto Rico bond valuations set new lows toward the end of June. What drove this latest market move?

Hammer: Over the last year, market consensus was that general obligation (GO) debt was senior in the capital structure to other PR debt and liabilities, primarily due to a constitutionally protected claim on the Commonwealth’s available resources. This view was turned on its head at the end of June with the release of a report by Anne Krueger, a former deputy managing director at the IMF, and statements made by Puerto Rico Governor Alejandro García Padilla. Krueger’s report cites large and growing cash needs that our bottom-up credit-screening process identified long ago. The report and the governor’s comments signal the need for a “comprehensive solution” entailing broader debt relief that would affect most parts of the PR capital structure, including GO bonds.

Puerto Rico also revealed that it has hired Steven Rhodes, the former U.S. federal bankruptcy judge who presided over Detroit’s bankruptcy case, as a consultant. Rhodes has since told Reuters that “the parallels between Detroit and Puerto Rico are strong enough that I think any of the public corporations or the Commonwealth itself could take advantage of the same kind of process that we used in Detroit.” In Detroit, pensioners fared significantly better than GO bondholders; pensioners received 75 cents to 90 cents on the dollar, while GO holders received 20 cents to 75 cents. If Puerto Rico is restructured similarly, it implies recoveries much lower than those implied in bond trading levels currently.

GO bonds were down 7 to 8 points during the week following the release of Krueger’s report. The most liquid bond traded down to $65, a record low, before closing the week at around $69; it was issued at $93 in March 2014.

Q: What is the outlook for the Commonwealth?

McCarthy: The summer will be unusually busy for the island. The governor has established the “Working Group for the Economic Recovery of Puerto Rico,” which is expected to provide legislators with recommendations for economic reforms and fiscal adjustments by August 30. Among the group’s goals, according to Governor Padilla, is a negotiated agreement with bondholders to postpone the payment of debt for a number of years. An exhaustive education campaign will follow to sell the recommendations to politicians, creditors and citizens.

On July 13, Government Development Bank (GDB) President Melba Acosta and several of the island’s advisors, including Krueger, met with creditors. During the meeting, the advisors avoided questions about specific plans to restructure public debt. The island intends to negotiate its capital structure on a case-by-case basis with creditor committees over the next several months. In the meantime, uncertainty over how divergent interests affect outcomes and the ability of issuers to make timely debt service may exert further pressure on bond prices. The GDB, Sales Tax Financing Corporation (COFINA) and the Puerto Rico Public Finance Corporation (PFC) all have debt service payable in August. We expect the GDB must reprioritize some payments given its precarious cash position, and on July 15 the island failed to appropriate $94 million to a bondholder trustee ahead of PFC’s August 1 debt service payment. We are interested in observing whether Puerto Rico will appropriate sufficient funds on time to make the payment and, if not, whether the island will concurrently default on COFINA’s August 1 debt service payment.

The failure to pay any August 1 debt service may also serve to pressure the U.S. Congress to more seriously consider extending Chapter 9 of the U.S. Federal Bankruptcy Code to PR’s municipalities and public corporations. The probability that the Code is changed for Puerto Rico is currently very remote; however, the U.S. Congress may eventually grant Puerto Rico’s municipalities and public