How Will Restructuring Plans Affect Puerto Rico's Bonds
A Look at the Plan to Put Puerto Rico on a Sustainable Growth Path
Puerto Rico’s year old debt crisis reached a new level on June 30 when President Barack Obama signed legislation that would restructure $70 billion worth of debt and install a federal oversight board to take charge of its finances. On July 1, the government defaulted on nearly half of $2 billion in debt payments that it owed to bondholders that were supposedly backed by an unlimited taxing authority with a greater priority than many basic government services.
In this article, we will take a look at the implications of the default and restructuring program when it comes to the island’s municipal bond market.
Restructuring Deal in Detail
President Obama signed legislation to create a fiscal oversight board that will be set up by September 15, 2016. Under the terms of the deal, the board will take a close look at Puerto Rico’s chronic budget deficits and determine how much debt will need to be restructured to put the economy back on a sustainable growth path. The process is expected to take at least six to nine months with a final decision due sometime next year.
The good news for Puerto Ricans is that Gov. Garcia Padilla’s decision to default on debt spared them from government layoffs and cuts to the health care system that could have resulted in a humanitarian crisis. While infrastructure work has stopped to a large extent, these processes could start to resume again when there’s greater certainty into the restructuring deal and growth path ahead, particularly if investors move back into the market.
Impact on Puerto Rico Bonds
The impact on Puerto Rico’s municipal bond market depends on a variety of different factors, including insurance policies and the government’s future decisions.
According to the WSJ, the three major bond insurers active in Puerto Rico are expected to cover as much as $358 million in losses stemming from the July 1 default.
Investors holding these insured bonds are unlikely to experience any losses and prices continue to trade near 100 cents on the dollar. The remainder of bond holders experienced a missed debt service payment, but they appear confident in some kind of resolution since they trade at 67.5 cents on the dollar.
The federal government’s new legislation prevents uninsured bond holders from suing the commonwealth until February 15 or six months after the board is formed. If the board decides that it needs more time, the moratorium could be extended for an indefinite period of time, which means that uninsured bond holders have little recourse at the moment. However, many seem confidence in a resolution judging by the market price of the bonds.
Impact on Other Markets
Puerto Rico’s default on general obligation bonds is unlikely to impact the larger municipal bond market, which has benefited from a combination of low-interest rates and a flight to safety among investors. Most investors view the commonwealth’s budgetary issues as very isolated, with the health of most U.S. states in the mainland faring much better. This is evidenced by near-record low bond yields for many muni issues in mid-2016.
The default could impact some financial institutions and mutual funds active in the municipal bond space, however. Oppenheimer Funds Inc. has nearly $7 billion in face value exposure to Puerto Rican bonds with the majority of those bonds uninsured. The same is true for Franklin Templeton, which holds roughly $2.7 million in largely uninsured bonds. While these institutions are large enough to absorb these losses, they could be a problem for mutual funds.
International investors should check for exposure to Puerto Rican bonds in any municipal exchange-traded funds (ETFs) to get an idea of what to expect. When doing so, it’s important to determine how much of the exposure is insured, since insured bonds are unlikely to experience significant losses in the event of a default.
The Bottom Line
Puerto Rico’s default on nearly half of $2 billion in payments that it owed shouldn’t come as a surprise to investors after a year of struggling with defaults.
With a fiscal oversight board in place, the federal government will be working to resolve the island’s chronic budget deficit and restructure debt in a way that’s fair to both parties. Until then, insured bondholders are likely to see full payment while uninsured bonds are likely to play a wait-and-see game.