A long-running debt crisis in Puerto Rico regained investor attention in recent weeks after the island’s governor stated that public debts of approximately $72 billion are essentially “not payable.” As a U.S. commonwealth, Puerto Rico does not have a clear legal framework to resolve its debt troubles. Most notably, neither the commonwealth nor its political subdivisions can seek bankruptcy protection as some U.S. municipalities have done in recent years. Thus, a restructuring of Puerto Rico’s debt will, in all likelihood, require consensual negotiations with a long list of creditors, including mutual fund companies, hedge funds and even individual investors.
Against this backdrop, some American Funds managed by the Capital Group have invested in certain types of Puerto Rican debt, primarily at discounted price levels that appropriately reflect what we believe to be the potential risks. Our total exposure is relatively small and it is represented by a broad spectrum of investments in nonprofit organizations, a limited amount of general obligation debt and revenue bond debt of related governmental entities, some of which is further supported by bond insurance.
The Tax-Exempt Bond Fund of America’s total exposure to Puerto Rico credits is less than 0.50% of total assets, with approximately half of that amount in insured bonds and the other half split among public and private entities in Puerto Rico. Among our national funds, the American High-Income Municipal Bond Fund has the largest exposure at just over 3%, with the highest exposure in insured bonds and public/private higher education and nonprofit health care credits. While we have somewhat higher total exposure in our state-specific municipal funds, due to the unique tax advantages of Puerto Rico credits, the investments are diversified across sectors.
Puerto Rico has responded to the debt crisis by raising taxes, cutting government spending and reducing pension benefits, among other measures. However, these fiscal reform efforts have fallen far short of the action needed to put the Caribbean island back on a sustainable course. In fact, the biggest problem is that Puerto Rico’s economy is shrinking by about 1% a year, according to a recent economic assessment report, making it difficult for the commonwealth to grow out of its debt burden.
Bond yields in Puerto Rico started moving significantly higher in 2013 to compensate investors for the higher levels of perceived risk. By early 2014, the major bond rating agencies downgraded the island’s debt to below-investment-grade status. Today, yields on Puerto Rican debt reflect a high probability of default. Efforts are underway to negotiate a resolution between the government, investors and other stakeholders.
“It’s going to be a complex process,” explains Karl Zeile, a municipal bond portfolio manager. “There is no mechanism in place for anything other than a consensual restructuring. But it’s going to be very difficult to bring everyone to the table and reach agreements that are acceptable to all of the interested parties, some of whom have competing interests.”
Given these difficulties, our research efforts have led us to favor the debt instruments of nongovernmental issuers, such as not-for-profit hospitals and universities, and bonds issued by government-related entities with dedicated revenue streams. These organizations are subject to the poor economic environment of Puerto Rico, which we must take into account, but they are not as directly affected by the government’s fiscal crisis. Therefore, we believe they present better investment opportunities, particularly at sharply discounted prices. We will continue to closely monitor developments in Puerto Rico and actively reassess our investment thesis, as always, taking advantage of our bottom-up fundamental research process.
Q&A With Karl Zeile on the Origins and Implications of Puerto Rico’s Financial Troubles
Given its high debt levels, how was Puerto Rico able to delay the day of reckoning for such a long time?
Puerto Rico was able to sustain its debt until recently primarily by rolling it over and taking on even more debt in order to stay current on existing payments. Puerto Rico has always been viewed as a heavily indebted U.S. commonwealth, but it has been helped along by the fact that Puerto Rican debt is exempt from state and federal income taxes everywhere in the United States. So if you are a resident of California or New York you can benefit from the special tax-exempt status of Puerto Rican bonds.
That advantage gave Puerto Rico the market access necessary to continue to fund itself in the municipal debt markets for a long time. And it has taken us to a point where Puerto Rico now has a debt structure that is completely unsustainable and will need to be restructured one way or another.
Why invest in Puerto Rican debt at all?
Not all Puerto Rican debt is the same. General obligation and certain government-related debt is where the biggest problems have emerged. But there are many types of bond issuers on the island and some of them are in better shape than others. We recognize that this is a high-risk but also a potentially high-return opportunity. We have made relatively small investments at what we believe to be attractive price levels in a number of our municipal bond funds. We believe we are being well compensated for the risk we are taking. It is always possible that our fundamental investment thesis will change and we will sell these securities. But for now each of those holdings represents our conviction about how we think this situation will ultimately be resolved.
What are the other types of investments in Puerto Rico?
There are several types of credits. There are those that are closely tied to the government. That first group includes sales-tax revenue bonds and Puerto Rico’s general obligation debt. Then there are quasi-governmental entities, such as the island’s water and sewer authority. That debt may need to be restructured, too. But at the same time, it has some positive aspects, because the water and sewer authority doesn’t carry an unsustainable amount of debt relative to the revenue it generates.
The next group includes insured bonds, which are primarily backed by Assured Guaranty. Those investments require a completely different type of analysis. Then the final group is nonprofit entities, such as private schools and hospitals. Although they face challenges operating in Puerto Rico, which is not a strong economy right now, they are otherwise separate and distinct from the debt burden of Puerto Rico’s government.
For these investment opportunities, we do the same type of credit work that we do on nonprofits in the mainland United States. We look at market share, reimbursement trends, doctor relationships, and so forth, and we develop an investment thesis. In some cases, we have found good revenue-bond credits and, because they just happen to be in Puerto Rico, they trade at significant discounts relative to their credit quality. We think many of those credits may be largely disassociated from the long-term government debt restructuring efforts.
Are there other examples of this dynamic in the municipal bond market?
Yes. We call it “guilt by association.” You see it in a lot of municipalities. We saw it most recently in Detroit. We purchased Detroit water and sewer bonds in the midst of the fiscal crisis because we thought it presented a good opportunity to invest in credits that were related to Detroit but had the benefit of a defined revenue stream for bond repayment. We have followed a similar approach in Puerto Rico.
How far have bond prices fallen in Puerto Rico?
We have seen some bonds fall below 60 cents on the dollar, reflecting a high degree of risk of repayment. The price action in recent weeks has attracted a lot of news coverage, and some bond prices have weakened further. But many Puerto Rican bonds were already trading at distressed levels.
Do you worry about the threat of contagion to other parts of the municipal bond market?
That is always a concern, but it’s important to note that Puerto Rico is different from any other municipal credit. Investors should not assume that, if Puerto Rico is in this situation, then other entities such as the city of Chicago or state of Illinois must be next. The current fiscal crisis in Puerto Rico is much more significant, and very different from the fiscal problems being confronted by some cities and states.
How did Puerto Rico get into this situation in the first place?
The financial problems that Puerto Rico is facing today started decades ago with the establishment of U.S. tax incentives for manufacturing companies to locate on the island. As a result, Puerto Rico developed a large manufacturing base, which grew significantly primarily because of the tax advantages. Starting in the 1990s, the incentives were slowly removed. What we’ve seen since that time is an island that invested too much in infrastructure improvements — highways, power plants, water projects, and so on — and a shrinking economy that can no longer support the debt that was issued to build this infrastructure. A sharp drop in home prices, distress in the banking sector and a declining population have added to the island’s woes.
Exposure to Puerto Rico in American Funds Municipal Bond Funds