Jul 29, 2015 - Peter Hayes
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This much we know: Puerto Rico has more debt than it can afford. Governor Alejandro Garcia Padilla told us so in late June when he pronounced the commonwealth’s $72 billion in debt was “not payable.”
After years of band aids and significant borrowing to meet its obligations, the time has come for meaningful reform. The question now is, what exactly will the island need to do to stay afloat, and what will it mean for creditors, particularly bondholders?
The only option
Given its multi-year recession, high unemployment, dwindling population, high energy costs (the list goes on), it seems clear to us that Puerto Rico is in no position to grow itself out of debt any time soon. Absent growth, the only other option for restoring some measure of financial integrity and standard of living for its citizens is to enact fiscal and structural reforms and restructure the existing burdensome debt, with the long-term goal of putting the island on a sustainable growth trajectory.
As the governor alluded June 29, “sacrifices” will be necessary to dig Puerto Rico out of its hole. Those concessions could be substantial for some creditors.
Sizing up the haircuts
By our estimates, the commonwealth needs to cut its current debt of $72 billion to roughly $40 billion. Our analysis suggests this would be a more sustainable level of debt for the commonwealth to carry relative to its potential gross national product (GNP). That’s a reduction of 44 percent.
Does that mean bondholders can expect to be paid back roughly 60 cents on every dollar of Puerto Rico debt owned? Unfortunately, it’s not that simple. The variables are many. In fact, we’ve looked at a series of scenarios (assuming a two-year settlement period) and arrived at a broad range of outcomes. We estimate recoveries could potentially range from 30 percent or less for subordinate, unsecured or appropriated debt to as high as 100 percent for bonds that are deemed by the courts as secured.
Also to be determined is the structure of bondholder haircuts. They might come in the form of a debt moratorium or potentially outright principal reductions, albeit the former is more likely. While much is uncertain, this is for sure: The total debt must be cut to a level more manageable given the island’s growth prospects. Current economic conditions, we believe, support the view that debt should be cut approximately 44 percent.
Making strides without Chapter 9
Complicating the commonwealth’s road to recovery is the fact that U.S. territories have no mechanism for restructuring debt. Puerto Rico does not have access to Chapter 9 bankruptcy protection, the process by which U.S. municipalities renegotiate their debt. The lack of formal procedures for implementing a broad-based restructuring could make it difficult to get creditors to the negotiating table. The result may be cramdowns vs. more conciliatory agreements. Undoubtedly, this will all be a long and contentious process, with the likelihood of many legal battles along the way.
Notably, two U.S. senators recently sponsored a bill seeking to extend Chapter 9 provisions to Puerto Rico. While that proposal is gaining some support in Congress, it is unlikely to come about in any timeframe that would facilitate the immediate needs.
Expect volatility, look for value
Puerto Rico will continue to make headlines. It’s a near certainty with the island likely to record its first default on August 1st (the commonwealth failed to make the necessary deposit to cover debt of its Public Finance Corporation due August 1st), and with the governor’s Economic Recovery Working Group expected to make reform recommendations by August 30th. The news flow will most certainly stoke volatility.
But make no mistake, the overall municipal market is on solid footing. Creditworthiness is strong and attractive relative yields should continue to draw demand for the asset class. The broad market notched negative returns in four of the past five months, but is up in July, notwithstanding Governor Padilla’s announcement.
We expect high yield funds could be most affected by events in Puerto Rico, as commonwealth debt makes up some 28 percent of the S&P High Yield Municipal Index. The potential for wider market disruption seems fairly muted, perhaps stemming only from investor overreaction to headlines. As such, Puerto Rico-related unease could produce value elsewhere in the market.
Even in Puerto Rico itself, all debt is not created equal. Some value could arise out of the melee. This points to the importance of thorough credit research to discern the differences between individual issuers and credits.
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