In the last two months, there have been reports and advisories from other firms that have been suggesting selling your Puerto Rico Bonds. Others, slightly less cautionary, have suggested reducing your holdings, or at least placing an upper limit to the percentage of Puerto Rico within your total holdings. One pundit suggested avoiding Puerto Rico bonds completely. Being contrarian from time to time, I would suggest that this is the wrong time to be shying away from Puerto Rico debt and its higher than average yields and triple-tax exemption advantage.
As a credit analyst who first saw Puerto Rico first-hand in 1977, I am fully aware of the stress this island commonwealth has suffered since before the Great Recession, and the apprehensions investors are getting from these negative headlines. Puerto Rico has long endured below average personal income and an economy built on relatively low paying tourist and service jobs, and above average government employment. Puerto Rico‘s economy is heavily dependent upon the U.S. economy, so when national headwinds blow, they often blow harder in Puerto Rico. It has had a history of modestly balanced budgets in good times and above average deficits during downturns. And its pension fund for government employees has historically been poorly funded.
These are not new developments; they are long-term characteristics of a unit that has not significantly changed its economic drivers nor its financial policies for decades. These characteristics were in evidence when Moody’s had Puerto Rico rated “A” in the 1970’s, and “A” by S&P as late as 2005. In fact, Moody’s recalibrated ratings and raised Puerto Rico to A3 in 2010; Moody’s downgrade to Baa1 just 1 year later still leaves Moody’s rating higher than it was from 2006-2010. And in March 2011, S&P actually raised Puerto Rico’s rating to BBB, only to threaten another downgrade little more than a year later. Fitch, in a first-time rating assignment, maintains a BBB+ on the Commonwealth.
While Puerto Rico’s problems have been chronic, the length and depth of the Great Recession has exacerbated these problems to unprecedented levels. The annual budget deficits became unprecedented, totaling $9.5 billion over the period from 2005 through 2012. The same kind of deficit growth could be said for both California and Illinois. Unemployment also exceeded expectations, much as it did in the U.S.
Unlike California and Illinois, however, Puerto Rico developed a multi-year plan to attack and reduce deficits, avoiding the annual squabbles and budget stalemates that marked both California and Illinois. The plan included significant tax increases and new taxes, but also included a curb on annual spending and a 17% reduction of the government work force. Puerto Rico’s administration has faithfully stuck to that plan. Granted, the plan involved significant long-term debt funding to meet budget shortfalls, but the same could be said for California in 2004, as well as for all the states that utilized more than $50 billion of tobacco bond money to fill holes in their annual budgets, including Illinois in 2010 and Minnesota in 2011. As the chart on the right shows, however, that the revenue increases and curtailed spending actions have gotten Puerto Rico to the point where ongoing revenue (without external borrowing) is trending and close to achieving structural budgetary balance.
Puerto Rico’s major credit risks on its very high debt load can be summarized into 5 main components:
Pension underfunding is the current buzzword in municipal finance. It is being used increasingly as a reason for rating downgrades, and has been described as a “ticking time bomb” that will lead to unprecedented defaults on municipal bonds. I wrote a piece 2 years ago saying that pension funding is not an immediate cash crisis for most issuers, but a problem that is long-term and can be solved gradually, without requiring that public pension funds need to be fully funded at all times.
In Puerto Rico’s case, however, underfunding reached a crisis stage. Historically underfunded at low levels (a fact known by analysts and rating agencies for decade), investment losses of nearly $800 million in 2008 & 2009 clobbered Puerto Rico’s Employees Retirement Funds assets, bringing their actuarial funding level to an unprecedented 6.8%. Until then, the Fund’s expenses generally matched revenue, and in 2008, the Fund sold about $3 billion of pension obligation bonds to shore up Fund reserves. Unfortunately, the bonds were sold at the outset of the financial crisis, leading the fund to lose money on its borrowing. And because of early retirements, pension payout benefits are expected to rise rapidly after 2011.
Unattended, this would precipitate a cash crisis within only 3-4 years.
In 2011, The Commonwealth passed a law that would require it to raise its contribution rate by 1% annually for 5 years, and by 1.25% annually for the next five years. This would result in Puerto Rico raising their contribution from 9.75% in 2011 to 20.525% by 2021.
Finally, despite the contribution increases, more will be need to be done. From 2005 through 2011, the Fund averaged 8.4% returns on its investment, despite losses in 2008 & 2009. In that environment, pension cash assets would decline, but at a slower rate. The Fund would need about an additional $400 million annually to keep net pension investment assets at current levels into the future.
One last positive note on Puerto Rico’s pension challenge: the Commonwealth stopped adding members to their defined benefit plan at the end of 1999, requiring new employees to join a defined contribution plan. So for the last 12 years, Puerto Rico has not been adding new members to their money-losing defined benefit plan. Most states and cities have yet to take that kind of action. As a result, others’ defined benefit plans are likely to continue to see pension funding pressure, while Puerto Rico’s will eventually wind down as retirees pass on.
Despite these daunting challenges, Puerto Rico has many basic strengths that can keep finances stable until an elusive economic recovery takes place.
These are my arguments for why investors should not be overly alarmed for their Puerto Rico bond holdings.
1. Puerto Rico Has State-Like Sovereign Powers. States as a category have had the lowest default rates of any municipal bond. Although Puerto Rico is not a state, it has many of the same sovereign powers that a state has, including the power to tax and legislate without interference from a higher authority. And unlike some states like California and Massachusetts, there are no constitutional or voter approved tax limitations that Puerto Rico is subject to.
2. The Economy Appears To Be Strengthening, And Benefits From No Federal Income Tax On Residents. After seeing year to year monthly employment declines for 57 consecutive months, Puerto Rico has now seen 9 consecutive year-to-year monthly increases. Puerto Rico’s low income levels can provide a cost-efficient working base for corporations willing to invest in the island’s economy. The Puerto Rico Industrial Development Company (PRIDCO) estimates that labor costs in Puerto Rico are about 20% lower than in the States. In addition, bona fide residents of Puerto Rico do not have to pay U.S. Federal Income Taxes, unless the income is earned outside of Puerto Rico or they are employees of the Federal Government. While the U.S. federal income tax burden is low or zero for many residents, the Commonwealth must maintain high taxation rates to offset the lack of federally funded spending programs. However, studies have indicated that the total per capita tax burden in the Commonwealth is lower than in the U.S.
3. Puerto Rico Retains Tax Advantages For Business. There remain some corporate tax advantages for locating business to Puerto Rico, even after increases imposed to address the deficit. For example, 16 of the 20 top selling pharmaceutical drugs in the United States are made in Puerto Rico. And the recent excise tax hikes have allowed some reductions in individual and business income taxes starting in 2011; those tax reductions are subject to rescission if certain economic growth and budgetary measurements are not met.
4. High Per Capita Commonwealth Debt Masks The Fact That Most Residents Are Not Paying For The United States National Debt. Studies show that per capita debt in Puerto Rico is more than 2 times the average for U.S. States; an argument can be made that debt is higher because it doesn’t receive the same federal spending benefits that states enjoy, so it must be funded at the local level. Moreover, it could also be argued that because bona fide Puerto Rico citizens do not pay federal income taxes, the crushing burden of the Federal Government’s debt does not weigh on most Puerto Rico residents. That puts Puerto Rico’s high debt burden in a different perspective.
5. Fiscal Reform Has Put The Commonwealth Close To Budgetary Balance. While Puerto Rico’s financial operations are checkered, much more fiscal discipline has been exerted by the current Governor Luis Fortuno since he was elected in 2008. Besides raising taxes (particularly a temporary excise tax increase for the Commonwealth and optional sales taxes for municipalities), the Governor’s plan to bring Puerto Rico’s budget back into long term balance enforced a 17% reduction in the government’s workforce. The original plan called for balance to be reached in the current fiscal year ending June 2013, but the continued sluggishness in the U.S. economy may cause the administration to fall short. Still, the annual imbalance has been reduced to a few hundred million dollars, compared to the multi-billion dollar deficits that met the Governor upon taking office.
6. Despite Operating Deficits, Some Borrowed Money Is Being Used To Jump Start The Economy. The deficit funding in the 2013 budget includes about $500 million for economic development incentives. While meager compared to the costs of maintaining annual government operations, investment into growing and diversifying the Commonwealth’s economy are important if long term fiscal stability can ever be reached.
7. The Government Development Bank Brings Advantages to Puerto Rico That Most States Cannot Avail Themselves. Puerto Rico has another advantage over most states because of its relationship with Puerto Rico’s Government Development Bank. This has been an important stabilizing factor and a facilitator of debt financing, including short-term seasonal cash flow notes. The GDB has also led efforts to improve the transparency of Puerto Rico debt and financial operations, transparency which is crucial for investors.
8. Stringent Long Term Plan To Balance Rising Pension Costs. While funding for Puerto Rico’s Employees Retirement fund is abysmal, the Government has taken a firm stance, passing a law which will require the Commonwealth to increase its contribution rate another 1% each year for the next 10 years, bring the employer contribution rate from 9.75% to 20.5% of employees’ covered salaries.
9. No New Members Being Added To Puerto Rico’s Most Expensive Retirement Program. The defined benefit plan was closed on December 31, 1999, shifting to a defined contribution system for new employees. So the cost of rising benefits will moderate more quickly than other states that continue their defined benefit plans.
10. Puerto Rico Will Not Be Bailed Out, But It May Be “Too Big To Fail”. Finally, an argument can be made that Puerto Rico may be “too big to fail”. I know that’s become a discredited term, but I don’t mean it in the way that there is a likelihood of a federal bailout; on the contrary, help might be offered by the Federal Government, but not in the form of bailout funds. In the worst case, Puerto Rico could be compared to NYC in the 1970’s-high debt, large deficits, and a weak economy. NYC was eventually rescued by the lenders that originally caused NYC’s debt to go unchecked. By investing in a newly created conduit borrower (the Municipal Assistance Corporation) with extra legal provisions to protect investors, these lenders returned to lending funds—the alternative would have been to write-off significant amounts of debt on their balance sheet. Puerto Rico has already created a safer conduit borrower called COFINA, which has a first legal claim on Commonwealth sales taxes. Because of the breadth and depth of Puerto Rico’s indebtedness, lenders would probably act the same way in order to protect their existing investment of over $60 billion of Commonwealth debt.
The rating agencies mostly have a negative outlook on Puerto Rico now; yet at the height of the Commonwealth’s financial problems in 2010 & 2011, Moody’s recalibrated the rating upward to A3 in 2010, and S&P upgraded the rating from BBB-to BBB in 2011. Throughout the last five years, low pension funding was acknowledged within the ratings. Yet it appears that as the government has taken actions to reduce deficit borrowing and bring Puerto Rico to its best operating state in over 10 years, further downgrades are being considered. Their timing seems to be way off. At this point, I worry more that the Commonwealth will keep on course as it has for the last four years, than what might come out of the rating agencies.
Keeping on its fiscal course will be a key factor in the November election for Governor. Policies and actions that move Puerto Rico back to its tax/borrow and spend budgets will change the course of this credit for the negative. For Puerto Rico to maintain its creditworthiness and its good relationship with the credit markets, anything less than maintaining its fiscal progress and efforts to control the stability of its pension funds will have disastrous consequences, after the strong progress made to “righting” the ship of state. Regardless of which party wins the election, fiscal integrity will be necessary—failure to do so will deepen Puerto Rico’s budgetary and economic challenges to the point where investors should then reconsider its position on investing in the Commonwealth of Puerto Rico.