Puerto Rico Insured: Third Quarter 2016 Review
Shaun Burgess, Portfolio Manager & Fixed Income Analyst
September 24, 2016
Puerto Rico started off the third quarter with a bang: a historic default and a seminal moment in the drama that has played out over the past two years plus on the little island in the Caribbean. Cumberland’s expectations of default were met in dramatic fashion, but so too was our long-standing presumption that the federal government would intervene. We did not expect that the government would allow three million American citizens to wallow in limbo, even with the staggering degree of dysfunction displayed by our elected representatives. Our strategy, however, did not rely on that outcome – as David Kotok likes to say, “Hope is not a strategy.” Our trust has always been in the insurers that we utilize, and they have so far not disappointed in living up to their obligations to pay principal and interest when due. This has been, and remains, the cornerstone of our Puerto Rico Insured strategy. The details of the Commonwealth’s default can be found in our previous commentary “Puerto Rico: The Days After.”
Of greater importance to the narrative has been the federal government, which, in a rare moment of bipartisan cooperation, passed The Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA). President Obama signed the legislation June 30, hours before the island experienced its largest default to date, including the nonpayment of the Commonwealth’s constitutionally backed debt. PROMESA establishes a federal control board to oversee the island’s finances and spending, and it also has the power to restructure Puerto Rico’s existing debts through court proceedings if consensual negotiations fail. It also provides a stay on litigation, which has been enforced in multiple suits in the months following PROMESA’s enactment. Establishment of PROMESA was a turning point for the island and will, we hope, right a ship that has been crippled through decades of borrowing, overspending, and mismanagement.
Defaults continued across differing authorities in August and September, though these amounts have been much smaller and far less consequential. We expect defaults to persist and uninsured bondholders to feel pain as bonds trade flat and restructuring negotiations commence. Outstanding and stayed litigations are stories that have yet to play out. Ultimate resolutions are up to the courts to decide. Their outcomes remain questionable in light of the powers afforded by PROMESA.
August saw President Obama fill the federal control board with the participants listed below. Their current positions are also listed in conjunction. Many observers, including Cumberland Advisors, are pleased with the bipartisan mix of individuals and their qualifications. Make no mistake; these folks have a daunting task in front of them. It will be many months before they have waded thru the island’s murky finances and adequately understand the scope of the island’s various credit structures and overlying claims. The oversight board has until September 30 to select a chairperson, who will then select an executive director.
Andrew G. Biggs – Resident scholar at the American Enterprise Institute (AEI)
Jose B. Carrion III – President and Principal Partner of HUB International CLC, LLC
Carlos M. Garcia – Chief Executive Officer of BayBoston Managers LLC and Managing Partner of BayBoston Capital LP
Arthur J. Gonzalez – Senior Fellow at New York University School of Law (NYU) and previously an adjunct professor at NYU
Jose R. Gonzales – Chief Executive Officer and President of Federal Home Loan Bank of New York (FHLBNY)
Ana J. Matosantos – President of Matosantos Consulting
David A. Skeel Jr. – The S. Samuel Arsht Professor of Corporate Law at the University of Pennsylvania Law School
We continue to wait for the ultimate conclusion to the restructuring of the Puerto Rico Electric Power Authority (PREPA). The requisite rate increases have been approved. The process is now with the rating services to review the special-purpose vehicle known as the Corporation for PREPA’s Revitalization (CPR). Expectations are for an early 2017 issuance of $7.8 billion in exchange bonds.
Uncertainties and unknowns remain, with eventual recovery values yet to be determined. However, we expect bondholders to fare better at the hands of a federal control board than they would have with Governor Alejandro Garcia Padilla, who has been extremely hostile to debtors. His questionably legal moratorium law, voluntary nonpayment of debt, and transfer of debt payments away from bondholders are a few examples of choices that validate our opinion of him.
Market response to restructuring events has been positive, with both uninsured and insured debt trading higher. Insured debt has seen significant gains with the insurers’ payments of principal and interest after the Commonwealth’s July 1 default, and it now trade at yields not seen since the inception of our Puerto Rico strategy. The fulfillment of insurer obligations was expected and came as no surprise. Our work regarding the insurers has been paramount to the success of our strategy. We expected the insurers we utilize to continue to fulfill their obligations and to leverage their capabilities and expertise in future restructuring negotiations.
Cumberland Advisors manages approximately $141 million in its Puerto Rico Insured strategy. We started the style in March 2014 with insured paper yielding between 6.5% and 7%. With yields now at 4%, and lower for many callable bonds, the value proposition still remains attractive in our opinion. Following the full payment of insured obligations, we have started to include a small allocation to carefully selected insured Puerto Rico bonds in both tax-free and taxable accounts outside of the strategy. We do so only with Assured Guaranty debt, which carries a rating of A2 by Moody’s and AA by Standard and Poor’s.
Cumberland Advisors’ Puerto Rico Insured strategy does not include uninsured debt from any island authority but focuses instead on the headline-driven opportunity in carefully selected insured debt. It is critical to examine the details of each bond indenture and the terms of each insurance contract. Blindly buying insured bonds is not a strategy we recommend.