, the municipal entity I receive the most questions about is Puerto
Rico - and rightly so. Puerto Rico faces economic and fiscal
challenges unlike those in any state; and because Puerto Rico bonds
are exempt from federal, state and local taxes in all 50 states,
they are very
. The situation in Puerto Rico can hardly be encapsulated in a
single blog post, but I wanted to point out a few key
considerations (good and bad) and offer some suggestions for
investors. The bad news on Puerto Rico has been
, so I'll start there.
The Commonwealth has a significant amount of debt. In fact, the
amount of debt relative to the island's gross national product
(GNP) is roughly 85%. Compare that to the worst state, which is
closer to 9%. Puerto Rico simply does not have the money to cover
its bills. The gap in the general fund budget has ballooned to
approximately $2 billion for fiscal year (FY) 2013.
Puerto Rico also has a narrow economy that has been in a recession
since 2006. Unemployment has been above 10% since the start of that
recession and currently is just above 14%. The tax base is not at
all healthy, housing affordability is worse than most places on the
continent and costs on the island are high. Consider that power
costs roughly 26 cents per kilowatt there vs. just 9 cents for the
U.S. states, and the island still has the burden of complying with
U.S. Clean Air laws.
Perhaps the number one issue in Puerto Rico relates to pension
liabilities and lack of funding. The island's three major pension
systems are funded at less than 10% today; the U.S. average is
about 73% and the worst state (Illinois) is approximately 43%.
Not bad … vs. sovereigns:
Puerto Rico's debt numbers look pretty dire compared to U.S.
states, but they are not much different from other sovereign
entities, including the United States.
The new administration in Puerto Rico has been very active in
proposing measures and taking steps to free up liquidity and to
ease the ailing pension system. In fact, we would award the island
a solid "B" on its efforts to fix its finances. Policymakers have
made changes to the pension system, raised existing taxes and
created new ones to the tune of potential billions in future
The effort has been impressive, but may be a case of too little
too late. Given the fiscal hole that exists and the lack of impetus
for economic revival, it will be difficult to move the dial in a
The Ugly Truth
Junk rating in waiting?:
general obligation (GO)
debt is currently rated BBB- by the agencies, still investment
grade. The market sees it another way (as evidenced by the
very high borrowing costs
being imposed for market access). Based on market pricing, the
implied rating is arguably already below investment grade.
Ultimately, a downgrade to "
" by the agencies will mean more forced selling, as
investment-grade portfolios are required to sell down their
non-investment-grade exposure to remain within investment
Despite a recent uptick, the Puerto Rico index is down more than
15% year-to-date. A downgrade could result in additional loss in
value - or worse, a deterioration in liquidity that would make it
difficult to get out of Puerto Rico bonds.
What's an Investor to Do?
Puerto Rico debt recently rallied as some investors appear to
believe the worst has passed. However, the underlying fundamentals
have not changed, and that will likely be acknowledged again by the
market. Until then, the recent strength might present an
opportunity for investors to pare back their exposure. More
broadly, we suggest investors keep an eye on their mutual funds.
Morningstar estimates roughly 77% of U.S. muni bond funds hold
Puerto Rico-related debt. Given the triple-tax-exempt nature of
Puerto Rico bonds, they are popular in national and state-specific
funds. Ensure that any of these types of portfolios you may own do
not contain a level of exposure higher than your comfort zone.
Above all, as I've said before,
is critical. There are big disparities across credits and issuers,
even in Puerto Rico. Knowing what you own can make all the
difference between success and failure in the muni market today.
Peter Hayes, Managing Director, is head of BlackRock's
Municipal Bonds Group and a regular contributor to
You can find more of his posts
Sources: BlackRock, Puerto Rico Commonwealth Financial
Information & Operating Data Report, Moody's, S&P, Bureau
of Labor Statistics, Puerto Rico Electric Power Authority.