Puerto Rico is crumbling under a recession and $70 billion in debt, some of which the Commonwealth defaulted on last year. While this may seem like a small and distant problem, the truth is that it puts the entire municipal bond market one domino closer to collapse.
What should happen is what normally happens in a default: All the creditors should sit down together and work out a comprehensive restructuring that doesn’t screw anyone over.
Instead, the parties involved have abandoned their responsibility, and leave millions of fixed income investors with increased risk in their municipal bonds.
Puerto Rico’s Crushing Debt
On July 1, Puerto Rico defaulted on its debt — the first time a state or Commonwealth has done so since the Great Depression — and did so by failing to pay $2 billion due to creditors. What’s especially astonishing is that the default occurred on general obligation bonds — bonds secured by the actual taxation authority of the municipality. Thus, these are generally considered the safest of all possible municipal bonds. If you can’t tax your way out of debt, you’ve got big problems.
Puerto Rico has big problems, thanks to a crippling recession.
Congress created the Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA), and a seven-person Oversight Board (OB) to right the ship. Governor Ricardo Rosselló was supposed to provide pro-growth reforms as part of this deal.
Instead, in March, PROMESA approved a plan that was a disaster for bondholders, canceling out 23% of the money they were due. That’s called a “cramdown” and in this case, a catastrophic one. Municipal bond funds fell around 2% at the time.
Congress shrugged its shoulders. Congress was happy to pass PROMESA but did nothing to push the Governor or the OB to make more significant cuts in spending, and found itself in a liquidity crisis last March.
This should come as no surprise. Recall that U.S. automaker bondholders were badly crammed down in the auto bailout. The great Todd Zywicki of George Mason University explains why that deal was bad for creditors and the rule of law, and the same logic applies here.
Puerto Rico’s debt will become much more expensive under a stupid deal like this. What lender wants to give Puerto Rico money knowing that the Commonwealth could default again, and they get 23 cents on the dollar? It’ll mean far higher interest rates for any money that does get lent. It will restrict outside capital needed to help get Puerto Rico out of recession.
My private equity contacts tell me that, after the auto bailout, they went on a capital strike that has not abated. They will not invest in companies where similar circumstances exist, in which some gigantic governmental body has the power to wipe them out. That’s one reason the recovery has been so weak, and you can imagine how that will impact Puerto Rico.
This is what happens when politicians get involved in these situations.
Governor Rosselló was supposed to right the ship. It’s why he was elected. The problem is that any politician’s primary goal is to hold onto power. That means short-term thinking and actions and not tough decision-making. What does he care if the bondholders only get 23% of what they are due? He just needs enough money to keep the place running.
His first plan was kicked back by the OB because — as often happens — its revenue projections were too optimistic. Where are the cuts to government jobs? Where was the effort to increase tax collection rates that are below that of the rest of the U.S.? How about making the tough choice to institute a value-added tax? Nowhere. Still.
Despite all this, a deal has been temporarily reached, and it is still awful for anyone holding municipal bonds. Not only does this 77% haircut still exist, but the GO bondholders are now fighting with the bondholders for sales-tax-backed bonds (COFINA bonds).
Of course they are. GO bondholders don’t want a 77% haircut, so they go after COFINA, claiming those sales taxes that were collected are unconstitutional. But then the COFINA bondholders get screwed. There’s even more duplicity with the Governor making a side deal with the holders of Puerto Rico Electric Power Authority (PREPA) bonds, who are only taking an 8% cut.
None of this is fair, and it wouldn’t be necessary if the politicians and the OB did the right thing and involved everyone in discussions.
Bottom Line for Municipal Bonds
So why does this matter? In the near-term, there are risks to both funds and ETFs with Puerto Rico bond exposure, and to the overall muni market. Remember that munis are already going to be under pressure, because as rates rise, the prices of bonds fall. The deal has not been finalized, and if it doesn’t improve, you are subject to risk from capital losses on broad muni bond funds of all stripes.
I found seven ETFs that have some exposure to Puerto Rico bonds:
- SPDR Nuveen S&P High Yield Municipal Bond (NYSEARCA:HYMB): 9.4%
- VanEck Vectors Short High-Yield Municipal (NYSEARCA:SHYD): 3.9%
- PowerShares New York AMT-Free Municipal Bond (NYSEARCA:PZT): 2.8%
- VanEck Vectors High-Yield Municipal (NYSEARCA:HYD): 2.2%
- VanEck Vectors Pre-Refunded Municipal (NYSEARCA:PRB): 1.4%
- PowerShares National AMT-Free Municipal Bond (NYSEARCA:PZA): 1%
- PowerShares California AMT-Free Municipal Bond (NYSEARCA:PWZ): 0.41%
Yet it is the long-term that I am concerned about. Municipal bond defaults are relatively rare, going back to the earliest days of such bonds. However, they are increasing in frequency and in size. We saw Detroit blow up. Now Puerto Rico. The more this happens, the more likely it is that other municipalities will go this route.
Yet the risk is particularly significant if restructurings are this colossally bad, as it was in Detroit. It encourages struggling municipalities to default, knowing that bondholders will get screwed. The more that default, the more risky the allegedly safe sector of municipal bonds will become.
For investors living on fixed income to see increased risk, for what is supposed to be a safe investment — that’s puts their limited capital at increased risk at a time when it isn’t supposed to be.
Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance. He has 20 years’ experience in the stock market, and has written more than 1,200 articles on investing. He also is the Manager of the forthcoming Liberty Portfolio. Lawrence Meyers can be reached at TheLibertyPortfolio@gmail.com. As of this writing, he did not hold a position in any of the aforementioned securities.
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