Puerto Rico: The Greece of the Caribbean?

24 August 2015

Since 2013, Alejandro Garcia Padilla, Governor of Puerto Rico, has been warning creditors that the United States of America Commonwealth territory’s debt load of US$72B is unbearable and needs to be restructured.  Well, on August 3, 2015, Puerto Rico defaulted on US$58MM in payments due on about 20 moral-obligation bond issues (it did pay US$628,000 on the interest).  It is the first time this has occurred since the island came under the jurisdiction of the USA 117 years ago.

How did this happen – Similarities and Differences with Greece

When Puerto Rico became part of the USA in 1898, its economy was fueled by coffee and sugar.  As agriculture declined, the US Congress approved financial tax incentives for manufacturers but those were phased out by 2006 (and the economy has been shrinking ever since).  Tourism played a major role in revenue generation but after the 2008 Global Financial Crisis, Puerto Rico, like most Caribbean nations that depend on tourism for economic growth, went into a steep economic decline.

However, Government spending to fund over-generous public payrolls continued unabated with budget deficits being financed with borrowings at cheap rates due to the fact that interest payments on Puerto Rico bonds are tax-exempt to US Mainland investors.  This attracted the big mutual funds like Oppenheimer and Franklin Templeton especially since the bonds were first given investment grades (but are now in deep junk territory).  The end result is that Puerto Rico’s debt tripled in the last 15 years. This is very similar to what occurred in Greece (deficit financing, cheap borrowing rates) except that Greek investors/lenders assumed the EU would back the debt.

Two big differences with Greece however, are that

  1. Puerto Rico debt ended up in the hands of Main Street USA via their mutual funds’ investments while Greek debt largely ended up in the hands of other European Sovereign Governments and Banks and
  2. Puerto Rico cannot exit the USA as a territory on its own volition, and like all other US States, cannot declare bankruptcy under Federal Law or repudiate its debts and devalue its currency like Greece can.

Compounding Puerto Rico’s problems is the fact that as US citizens, they can migrate to the mainland freely and at present it is estimated that a third of the its people born on the island live in the USA, leaving a withered tax base. Emigration has increased recently as the implemented austerity programmes are causing a recessionary environment.  As the Governor said “Puerto Rico is trapped in a vicious cycle of contraction, emigration, austerity and taxes”.

The Now

Puerto Rico needs to sell US$400MM of tax-and-revenue notes to help finance day-to-day operations beyond November and have already alienated investors with the default on the US$58MM bond issues.  However, they expect investors to provide the necessary liquidity after unveiling their debt restructuring plan on September 1.  Without additional borrowings, the government will have to consider further furloughs, payment suspension to suppliers or extending IOUs. Puerto Rico and its agencies face US$1.4B in principal and interest payments in December and January and may need to borrow well beyond US$400MM according to Bloomberg.

Puerto Rico’s Aqueduct and Sewer Authority, known as Prasa, was going to test the market with a US$750MM 30-yr revenue bond issue (underwritten by Bank of America Merrill Lynch) on August 20 but that was shelved until the following week.  The target market is High-yield Mutual Funds. Although the bond will have a dedicated revenue source in the form of user fees, it is anticipated that the coupon rate will be around 10%.  Prasa’s 5.25% coupon 2042 bond traded on August 20 (day of this writing) at 63.25 cents on the dollar for a yield of 8.8% percent.

At present the yield curve on Puerto Rico bonds is inverted with 1-year debt yielding 39% and 23-year debt yielding 10% (see graph below).

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In June S&P (along with the other major rating agencies) lowered all of Puerto Rico’s debt from CCC+ to CCC- with a downward watch.

Banking Sector

In a report from Bloomberg and Fitch, it was reported that Puerto Rico banks should have sufficient capital to withstand or absorb any future losses.  Banco Popular, Puerto Rico’s largest bank has about US$1B in exposure to the Government.  Banco Popular and First BanCorp have been able to sell off their bad debts without having to provide any type of seller finance or other type of loan to the purchaser (a true sale with the risk removed from the balance sheet).  Also, the island has a very limited rental market and most borrowers have equity in their homes and will do what is necessary to keep their accounts current at the banks.

The Way Forward

The Padilla Administration is pushing for the right to send its cities and school districts into Chapter 9 municipal bankruptcy but Puerto Rico is not a State (the US bankruptcy code does not allow States to declare bankruptcy but does allow States to have their municipalities declare bankruptcy.  The definition of a Municipality is broad enough to include cities, counties, townships, school districts and public improvement districts).  However, this proposal has no support of the Republicans in control of Congress.  The White House said that a federal bailout is not under consideration.  If Puerto Rico does not get some federal help before Congress’s August recess, we can expect further defaults on other bond issues.

The Padilla Administration is expected to produce a restructuring plan by the end of August.  Options include voluntary debt exchange programmes which usually will include deep haircuts; exempting Puerto Rico from the federal minimum wage law; and a law that bans shipments by foreign-flagged vessels.  We expect the Barack Obama Administration to offer some help to its Caribbean outpost especially since Puerto Rico attracts the third highest (behind Dominican Republic and Cuba) stay-over visitors for tourism in the Caribbean.

In 2013, Grenada also issued a similar warning on its US Bond and EC Bonds (US$262MM) due 2025 and eventually defaulted.  Grenada had been devastated by Hurricanes Ivan and Emily in 2004 and 2005 respectively and the Global Financial Crisis of 2008.  However, in 2015, Grenada was able to restructure its debt after entering an IMF programme where investors took a 50% haircut (loss on the face value of their holdings).  Well, although Puerto Rico, a territory of America, cannot on its own enter into an IMF programme, is a haircut coming to investors?

Stay tuned.

Sovereign and Quasi-Sovereign Indicative Levels

As we usually do, here are some (extremely) indicative prices coming out of the Caribbean bond market this morning. Given the international market tumult, from China and spreading outwards (though you might agree, there is no discernible sovereign head nor tail to these current market fluctuations), please treat these as current only at the time of writing and so call our trading desk for more up to date information.

We’ve highlighted bonds that are actively trading and many of the issuers have bonds of other maturities if you are so interested.

In addition, we’ve highlighted some home-grown issues which might be of interest. Call or email for further details.

New Horizon: Company operating oil well from a Petrotrin Farmout where the production is sold back to Petrotrin

Operational Support Services (OSS) – Company providing Casing services that is required in the drilling of oil and gas wells

Dwellings – Barbados retailer of furniture and home appliances

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