- The July 1 default by Puerto Rico could temporarily put stress on the municipal bond market
- The federal PROMESA bill, while not a bailout, offers a long-term path for Puerto Rico’s debt restructuring, but is not a silver bullet
- We remain cautious on Puerto Rico debt, but the overall municipal market should weather the short-term risks
The news on Puerto Rico demonstrates how negative headlines in the municipal bond market can sharply contrast with positive market conditions, as the July 1 Puerto Rico default may briefly trouble an asset class that is generally stable.
Puerto Rico struggles with long-term disadvantages
The U.S. Commonwealth of Puerto Rico is engrossed in a long-term debt challenge, having borrowed massively even as its economy has struggled with a variety of setbacks. After several years of weakness, the island’s government debt is currently among the most distressed in the entire municipal market.
The crisis in Puerto Rico is primarily driven by 10 years of economic contraction since the loss of federal incentives that had previously fostered growth, coupled with aggressive debt policies and an inability to control spending. Over the past 15 years, the island’s population has dropped 9% (Source: U.S. Census Bureau) and real estate values have fallen significantly. The long-term result is that the per capita debt burden in Puerto Rico dwarfs that of all U.S. states.
Legal issues have complicated debt restructuring
Puerto Rico lacks the legal power that municipalities possess to proceed with debt restructuring under federal law. Finding an alternative way to move forward has involved action — and delays — by both federal courts and Congress.
In an effort to resolve the crisis, Puerto Rico crafted new bankruptcy provisions, but early in June the U.S. Supreme Court ruled that these provisions violated federal law. The high court agreed with two lower court decisions brought by creditors that had already gone against the Commonwealth.
Eleventh-hour Congressional action provides a path forward
With Puerto Rico’s efforts derailed, Congress stepped in. In early June, the U.S. House of Representatives approved a bill known as PROMESA (Puerto Rico Oversight, Management, and Economic Stability Act). On June 29, the U.S. Senate passed the PROMESA bill as well, and it was signed by President Obama on Thursday, June 30.
PROMESA, while not a bailout, creates a federal control board to oversee and facilitate the island’s fiscal management, and it will also provide a bankruptcy-like restructuring template in the event that a consensual agreement is not reached with creditors. Negotiations with bondholders are currently at a standstill.
We expect implementation of PROMESA to take years, rather than days or weeks. We will be monitoring the progress of PROMESA for the potential implications it might have for other types of credit issuers in the future.
We think it is prudent to remain cautious regarding Puerto Rico debt. The Commonwealth’s credit fundamentals continue to be weak, based on the recent Economic Activity Index of the Government Development Bank for Puerto Rico, and we expect the island will continue down the road of restructuring. It took a long time for Puerto Rico to build up its excess debt; similarly, it will take a long time to stabilize its financial situation.
The July 1 default is being felt by Puerto Rico’s creditors. Putnam funds have very little exposure to Puerto Rico (from 0% to 3% as of March 31, 2016). This is a testament to our fundamental credit research process by which we review each bond that we put into our portfolios to assess risk across a number of elements.
Credit risk, technical conditions, and interest-rate trends all play a role in today’s market
Despite the recent headlines about Puerto Rico, we believe that munis still present an attractive long-term investment option for clients. Municipal bonds as an asset class have a long history of providing a durable stream of income with very few years of negative total returns.
Demand for municipal bonds is strong, in part because they offer more attractive yields when adjusted for taxes than many other income-generating securities. Inflows to municipal bond funds across the industry are near a record-high pace, while demand from banking institutions is also vigorous. Even international buyers are attracted to U.S. municipal bonds as many non-U.S. sovereigns offer negative yields.
While we continue to monitor interest-rate risk closely, conditions in 2016 thus far have been generally favorable due to global uncertainties, a flight to quality, and strong market technicals. In addition, the Fed has struck a more dovish tone since the start of the year, as a “data dependent” approach has kept the central bank on the sidelines. Most recently, the unexpected result of the Brexit referendum in the United Kingdom has put downward pressure on U.S. and global yields. This event appears to lend credence to the idea that the Fed will remain neutral in coming months, but we will continue to analyze emerging data closely given the impact that interest-rate risk can have on the municipal market. We have worked together for over 27 years, gaining experience in all types of economic and rate cycles, and our team includes experienced credit analysts who continue to scour the muni bond market to evaluate and identify attractive relative value opportunities.
302075
