Puerto Rico Bonds Part II: Understanding the Volatility

Follow-up to February’s article Puerto Rico: A Delicate Balancing Act. 

In June of 2014 the Commonwealth of Puerto Rico’s legislature passed the Puerto Public Corporations Debt Enforcement and Recovery Act (the Act) for restructuring the outstanding debt of public corporations. Its passage got a cold reception from the municipal bond market.

The market immediately bid-up the yields (prices fell) for the outstanding bonds of Puerto Rico Electric Power Authority (PREPA), Puerto Rico Aqueduct and Sewer Authority (PRASA) bonds, and the Puerto Rico Highway & Transportation Authority (PRHTA), as these public corporations are more likely to undergo a debt restructuring. Not surprisingly, Puerto Rico general obligation bonds experienced an increase in yields. Pioneer Investments does not hold any Puerto Rico bonds in its open-end mutual funds. 

Puerto Rico Debt Bond Yields iii jpgCredit Ratings Downgraded In addition to the yields increasing on its outstanding debts, Puerto Rico’s credit ratings were further downgraded by each of the three rating agencies (see table). This is significant since no other state in the U.S., or state equivalent territory of the U.S., carries a below-investment grade credit rating. The downgrades by Moody’s Investors Service (Moody’s) of the PREPA, PRASA and PRHTA bonds to Caa quality (highly speculative, non-investment grade) had the largest ripple effects in the municipal bond market. Moody’s downgraded Puerto Rico’s general obligation (GO) bonds to “B2” (very high credit risk) from “Ba2” (high credit risk). 

Puerto Rico Debt Ratings

The Legislature’s Balancing Act Continues Puerto Rico government’s leadership continues to face a true “budget balancing” act in the very near-term (within the next 12 months). Unaudited operating results for Fiscal 2014 (ended June 30, 2014) suggest that the Commonwealth was able to lower its budget deficit to $740 million for the fiscal year, improving on an estimated budget deficit for the fiscal year of $820 million. Positive increases from the Foreign Tax (Act 154) and corporation taxes were the main contributors to reducing the Commonwealth’s budget deficit in Fiscal 2014. However, corporate tax collections still greatly under-performed budget estimates by 23.8%, or $599 million. This was due in part to 53% of corporations extending their tax payments to July 15, 2014. As it works towards achieving a structurally balanced budget, Puerto Rico’s leadership has continued to demonstrate strong political will by restructuring its state employee pensions, including freezing benefits under defined-benefit plans for employees in the public pension system who have not yet retired, increasing retirement age, and increasing required employee contributions to the system. Likewise, the Commonwealth has enacted a similar restructuring to its Teachers Pension Program. Passage of the Act, is an attempt to allow the Government Development Bank to use its receipts only for general fund-related purposes. The intent of the Act is to make Puerto Rico’s public enterprises self-sustaining like other governmental enterprises in the U.S. 

Puerto Rico Must Grow its Revenue But Be Careful How it Legislates As the unaudited financial operating results for Fiscal 2014 suggest, the Commonwealth made some positive steps toward establishing a structurally balanced budget. In Fiscal 2014, the Commonwealth was able to increase its general fund revenues while simultaneously reducing expenses related to pension contracts and staffing levels. However, the Commonwealth must find a way to expand its economy in the near-term if it truly wishes to grow its revenue base as part of creating long-term fiscal stability. Likewise, it must be very judicious in legislating to assist the process. Passage of legislation, such as the Act, could have an unintentional negative impact by sending the wrong message to the municipal bond market resulting in more costly bond financing efforts in the future. Puerto Rico’s current leadership has made considerable progress toward creating a balanced budget. The bonds issued by and for its public corporations, however, may be under considerable short-term stress as municipal bond market investors figure out the implications of the Act.

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About Jonathan Chirunga

Jonathan Chirunga is Vice President at Pioneer Investments. He is Portfolio Manager for Pioneer High Income Municipal Fund and Pioneer AMT-Free Municipal Fund. Jonathan joined Pioneer Investments in 2011.
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