David R. Kotok,
Cumberland Advisors, October 16, 2013
Puerto Rico is not the federal government. It is an important debt problem.
Some readers saw the Barron’s front-page article on Puerto Rico and its financial problems. The details of the debt burdens of Puerto Rico make for an ugly picture.
Puerto Rico bonds are ubiquitous. They are tax-free in all state jurisdictions because of the particular nature of Puerto Rico’s territorial commonwealth status. Many mutual funds hold (or held) them because they can be placed in state-specific funds and in more general funds.
We have seen five months of mutual fund liquidation pressure, which originated in part with Puerto Rico credit risk. The pressure was exacerbated by tapering talk from the Federal Reserve and again intensified with the federal political impasse. Other credit-related events such as Detroit’s bankruptcy added fuel to the liquidation fire.
Where do we stand now? The Puerto Rico Commonwealth debt obligations are rated Baa3 by Moody’s, BBB- by Standard & Poor’s, and BBB- by Fitch. Some other securities issued by Puerto Rican agencies are below investment grade. The ratings just recited are the lowest of the low investment grades. Market-based pricing in Puerto Rico debt reflects market perceptions of imminent cash exhaustion. We see PR bonds that are backed by Assured Guaranty, the US bond insurer, trading at yields close to 7%. We see uninsured, unenhanced Puerto Rico credits trading at double-digit yields. And we see short-term Puerto Rico debt trading at annualized yields well into double digits.
The market is saying that Puerto Rico could run out of cash. This market-based pricing suggests that Puerto Rico could default, declare some legal action, or otherwise jeopardize the payment stream to bond holders. We think that is a very serious risk. Market based pricing suggests that PR will not easily “roll” its maturing debt.
The political questions surrounding Puerto Rico are equally complex. Puerto Rico is a sovereign commonwealth; it is not a state or city. It has never held a vote to support an application for statehood in the US. Puerto Rican residents do have US citizenship status. If Puerto Rico were to bankrupt or default and then try to achieve statehood in the US, would it be accepted? There is no reference in American history regarding the legal status of a territorial jurisdiction like Puerto Rico seeking direct assistance and federal guarantees under conditions like these. PR has benefitted by many special tax treatment related subsidies in the IRS code.
Additional serious political questions arise out of the imbroglio currently playing out in Washington, DC. If the federal government does not inject money into a city like Detroit, Harrisburg, or Stockton, would that same federal government use the US credit to support the refinancing of Puerto Rican debt? All of the political questions involving Puerto Rico are profound and their answers highly uncertain, but we believe that a bailout of Puerto Rico is unlikely in the present political environment in Washington.
Cumberland has not taken any positions in Puerto Rico that are in unenhanced credits. We have avoided them. When clients hold them in accounts that come in, we attempt to sell them, and those sales are increasingly difficult. We have held Puerto Rico bonds that are pre-refunded: that means they are secured by an escrow of US Treasury obligations. And we have held bonds that are guaranteed by Assured Guaranty, Inc. AG is rated favorably by both Moody’s and Standard & Poor’s. Would we buy new bonds in Puerto Rico if they were insured? The answer is, probably not. And we doubt that insurers would take on more PR risk. Would we buy any of the unenhanced Puerto Rican debt or standalone credit? The answer is, definitely not.
In contrast to a separate-account manager such as Cumberland Advisors, the mutual fund manager faces an acute difficulty. Let me describe it in the following way. A mutual fund manager has a collective fund of tax-free bonds and may be facing shareholder redemptions. That means the manager must sell, raise cash, and pay the shareholders on demand. If the manager owns some Puerto Rico debt and must sell it, enormous losses will be taken, because the pricing of that debt is as I have described. There is no longer the ability to easily sell Puerto Rico debt.
So what can be sold by the fund manager instead? The highest-grade, most liquid, and easily traded securities can be sold. However, if mutual fund A is facing redemptions, it is likely that mutual funds B, C, D, and E are also facing them. So the natural buyers for the bonds held by A become sellers instead, just like manager A is a seller. The end result is wholesale selling, and the selling by mutual funds is across the board, not idiosyncratic to one fund.
Who is on the buy side? Only separate-account managers who can cherry pick the offerings. That is what we do. We look at bid-wanted lists. The bids we give are bids that we think are bargain bids for bonds that we know we want to buy for our clients. Do we see Puerto Rico bonds offered? Yes, of course. They are distressed sales coming from institutions that are under pressure. That is the time when a separate account can be opportunistic. Taking advantage of opportunities is what we try to do, but only when we believe those opportunities will pan out.
We seriously question whether Puerto Rico can make it. There are arguments being put forth about using casino revenues, sales tax revenue, and other collateral to secure financing. We are skeptical. We think the commonwealth is facing huge difficulty in rolling over their maturing debt. The climactic Puerto Rico chapters of the municipal bond book are being written now. We advise reading and watching with professional interest. But we do not advise owning Puerto Rico.
We want to offer some special thanks to Natalie Cohen, Head of Municipal Research at Wells Fargo Securities, for her excellent work in the municipal bond arena and specifically on Puerto Rico.
We also want to note that the slides and presentations made at the October 10-11, 2013, Global Interdependence Center conference in Bermuda are now posted on the GIC website, www.interdependence.org. Included in those presentations and slides is an entire section on municipal debt. It includes comments about Detroit, among other jurisdictions, and references Puerto Rico. The participants in the first session on cities were Peter Gold of the Peter Gold Group, Mary Francoeur of Assured Guaranty, and Dennis Archer, former mayor of Detroit. The second session was moderated by my colleague John Mousseau and included presentations by Catherine Mann of Brandeis University and Robert Kurtter of Moody’s Investors Service. Those presentations focused on municipal credit and the issues of cities – whether they can be saved, how they can be saved, and the mechanics of municipal finance. I can report to you that during those two sessions that morning, the attendees were very attentive and strongly responsive to the information that was presented. In fact, I would say that people were riveted.
We encourage readers to view those presentations. In some cases, new data was presented that had not previously been broadly shared in an open-forum conference.
David R. Kotok, Chairman and Chief Investment Officer, Cumberland Advisors