There is an old saying which reads: “There is no rest for the weary” (some sources state the correct saying is “there is no rest for the wicked”). Either version could apply to Bond Squad during this, our vacation week.
The latest event to encourage us back to our appointed rounds was news which broke late last evening that Puerto Rico seeks to restructure debt backed by utility and highway revenues. In the bond world, a debt restructuring is tantamount to a default as it almost always results in affected bond holders receiving less than par (less than full return of principal) and cessation (probably permanent) of interest payments. As of now, Puerto Rico Commonwealth General Obligation bonds and sales tax revenue bonds (Cofinas) are not affected. In fact, according to Puerto Rico authorities, haircutting bonds backed by electric, water & sewer and highway revenues, enhances the probabilities that Puerto Rico will be able to service its General Obligation bonds. Sales Tax bonds are backed by sales tax revenues. Unlike with the aforementioned utility bonds, there are currently no claw-back provisions in sales tax revenues into the general fund. This was reiterated last evening by Puerto Rico government officials.
Restructuring has not been launched. The government “seeks” to restructure debt if necessary (which it probably is). However, the Government of Puerto Rico has started the process which could lead to a restructuring. This is a first, but significant step toward debt restructuring.
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For the past year, we have advised readers about the potential dangers associated with Puerto Rico debt. As we feared that a debt restructuring was possible, we advised readers who sought exposure in Puerto Rico debt to focus on Commonwealth GO bonds and Cofinas. We suggested staying with the shortest maturities possible (if one was inclined to take such risks in the first place). Public corporations (the aforementioned utilities) account for nearly 40 percent of the island’s $70 billion debt load, with the state-owned power company carrying $9.3 billion in debt, the highway and transportation authority $7.1 billion and the water and sewer company $5.1 billion. Haircutting investors could provide significant relief to Puerto Rico’s balance sheet. Of course, if the Commonwealth cannot solve its woes, further bondholder-unfriendly actions could occur.
Puerto Rico’s governor, Alejandro Garcia Padilla, assured the public that the measure does not apply to the government’s general obligation debt and that it also excludes the island’s 78 municipalities, the Government Development Bank and other entities. Our advice to readers is: If volatility and the threat of having income interrupted and principal returns trimmed, one should probably avoid Puerto Rico debt. At the present time, we believe bond insurance should be there for investors of insured debt. It is likely that investors holding the affected bonds will attempt to fight the restructuring in court, but they probably have an uphill climb ahead.
This should be a lesson for investors who have become desensitized to risk and have reached into risky credits in search of yield. Fed policies have pushed investors into increasingly risky and opaque debt instruments to generate attractive returns. Investors appear to be underpricing risk as bond defaults have been near record lows. However, there is a kind of self-fulfilling prophecy at work here, one in which investors’ hunger for yield is what is keeping defaults low. As soon as the Fed accommodation music stops, many investors will scurry to safer opportunities (which should return more if rates rise). Unfortunately, many complacent investors will probably find themselves without a seat when the music stops.
We remain unconstructive on Puerto Rico debt. If one is inclined to speculate on Puerto Rico debt, we would advise Commonwealth GOs and Cofinas with maturities inside 2.5 years. Investors who are counting on coupon payments and full return of principal should consider insured bonds or opportunities elsewhere in the fixed income world.
By Thomas Byrne – Director of Fixed Income – Investment Consultant
Thomas Byrne brings 26 years of financial services experience to Wealth Strategies & Management LLC. He spent the last 23 years as Director of Taxable Fixed Income for Citigroup, Inc. and predecessor firms in New York, NY. During the course of his long fixed income career, Mr. Byrne was responsible for trading preferred stock, corporate bonds, mortgage backed securities, government debt, international debt and convertible bonds. Mr. Byrne was also responsible for marketing, sales, strategy and market commentary within the taxable fixed income markets.
- November 2012 – Present, Wealth Strategies & Management LLC, Stroudsburg PA
- December 2011 – November 2012 – Bond Squad, Kunkletown, PA
- April 1988 – December 2011, Citigroup and predecessor firms, New York, NY
- June 1986 – March 1988 – E.F. Hutton, New York, NY