In a May blog post on Puerto Rico bonds, we commented on why we had chosen not to hold the island’s debt in our municipal portfolios. Puerto Rico’s Governor has since said the debt is “not payable” and former International Monetary Fund officials, including former first deputy managing director Anne Krueger, recommended debt relief in a report commissioned by Puerto Rico. These events were no surprise, but future developments are less predictable.
These are the key issues:
- Unsustainable debt. Puerto Rico’s debt is not sustainable without real economic growth and a consolidated surplus. These will remain elusive over the next several years by any reasonable estimate. One-off improvements in socioeconomic metrics do not imply debt sustainability. Yes, federal transfers will soften the blow, but difficult fiscal adjustments will occur and sacrifices will fall disproportionately on creditors.
- Nominal haircuts. Officials have suggested they will impose haircuts by seeking to negotiate payment terms, but not a reduction of principal. We consider the growth scenario and Krueger’s analysis optimistic. It demonstrates debt service costs in excess of 30% (of consolidated revenues excluding federal transfers) between 2016 and 2025. Adjusting to a sustainable servicing capacity over the longer term would necessitate larger haircuts through reduction of principal; if not, then Puerto Rico, like Greece, faces future rounds of restructuring.
- Roadmap to Chapter 9. The island hosted a meeting with creditors on 13 July to discuss Krueger’s recommendations. The meeting was uneventful, but the purpose may have been strategic. Puerto Rico’s public corporations and municipalities are not eligible for Chapter 9, but legislation has been introduced in the U.S. House of Representatives to extend the U.S. Bankruptcy Code to Puerto Rico. To qualify for Chapter 9, municipalities must demonstrate insolvency and good-faith negotiation with creditors. To that end, the meeting was deliberately perfunctory. The probability that Washington changes the code for Puerto Rico is currently remote; however, eventually, Congress may begrudgingly grant Puerto Rico access to Chapter 9 as a path of least resistance when faced with disorderly outcomes and less democratic alternatives (e.g., a federal control board).
- Legal protections of liens are untested and highly unreliable. We have long believed Puerto Rico’s capital stack will be reprioritized and the sanctity of revenue pledges is at risk. Existing remedies in the event of default are generally weak, and the preservation of liens in a comprehensive restructuring is uncertain.
So what’s next?
A new committee set up by the Governor will provide recommendations to legislators regarding fiscal and economic reform by 30 August. The committee includes the speaker of the Puerto Rican House of Representatives and the president of the Senate and should be viewed skeptically by creditors. The Commonwealth will also establish a financial control board to implement, and maintain adherence to, the committee’s recommendations across administrations.
Granting the control board authority introduces heightened political risk. In the meantime, uncertainty over debt modifications may exert further pressure on bond prices. The island’s advisors intend to negotiate with individual committees over the next several months. However, indentures do not provide collective action clauses and no process exists for “cramming down” modifications on holdouts. We expect discussions to devolve to litigation, particularly between holders of general obligation and sales tax bonds. Puerto Rico’s adjustment will take time, hardship, litigation and substantial debt relief.
Read more: PIMCO Insights on Municipal Bonds