Puerto Rico’s financial struggles have drawn wide attention, and many investors are evaluating the short-term and long-term outlook for the territory’s debt. PIMCO remains unenthusiastic about investing in Puerto Rico debt for a number of reasons:
- Debt levels are not sustainable. Puerto Rico cannot continue raising cash each year at elevated yields with an economy contracting.
- Increased execution and policy risk. Puerto Rico’s political discord has accelerated ahead of the 2016 elections.
- The pitfall of deep austerity. The government must now adopt draconian budget cuts. Feedback loops will drive more of the labor force underground, orphan public corporations, reduce tax receipts and exacerbate the downward economic spiral in the short run. The degradation of public services will accelerate population flight as it did with Detroit.
- Liquidity does not solve insolvency. Austerity does not solve out-year fiscal dilemmas, including pension insolvency, healthcare shortfalls, and impending changes to a large tax item concentrated across a few taxpaying entities. Too much depends on favorable lobbying outcomes, but actions to date suggest Puerto Rico will not succeed (e.g., the recent ruling by the Centers for Medicare and Medicaid Services to cut the island’s Medicare Advantage rates by 11% ). Fiscal measures alone will not solve the island’s structural issues, including population flight, demographics, secular manufacturing retreat and limited global competitiveness.
- Ring-fencing remains elusive. The piecemeal disentanglement of public corporations from the central government threatens to do more harm than good. The specter of default is creating collateral damage by impairing access to capital markets for performing public corporations. Holding out hope for a reversal of a federal district court’s February 6 unconstitutional ruling on Act 71-2014 (the “Recovery Act”) or the passage of H.R. 870 by the U.S. Congress is a dubious strategy.
- Capital structure is too complex. The capital stack may need to be reprioritized and the sanctity of revenue pledges is at risk. Politics threaten to subordinate debt service to preservation of legitimate public interests, including pension benefits. Support for a constitutional amendment and referendum to protect pension benefits may not be difficult to achieve, given that residents are owed $34 billion of unfunded pension liabilities. Retiree benefits, not creditors, are the winners in recent municipal restructurings, and long-established payment priorities often dissipate in extraordinary restructurings (e.g., Chrysler and General Motors).
- Willingness to impair. Pension reform and a recent dispute with a financial institution demonstrate that Puerto Rico has a willingness to impair contracts. Some influential politicians have suggested a constitutional amendment to allow default on General Obligation debt. Similar thoughts may be rekindled as legislators consider austerity measures.
- The mean reversion trade is over. Favorable outcomes in the near term will provide a short window for many trapped long-only investors to exit positions, provided new buyers emerge (is there a greater fool?).
- Unknown-unknowns. It’s difficult to have conviction on recovery targets and outcomes with the information asymmetry that is so endemic to Puerto Rico.
Read more: PIMCO Insights on Municipal Bonds