The Fun Begins

Author: Michael Comes, Shaun Burgess, John Mousseau, Post Date: September 18, 2015

Midsummer of this year, Anne Krueger, a former IMF economist, published a plan to fix Puerto Rico’s finances. Her estimates suggested that a cumulative financing deficit of $9.64 billion is needed to be plugged with expense reductions or creditor impairments to fix the island’s finances. Last week, a “working group” of Puerto Rico’s governor, the head of the Puerto Rico Government Development Bank, and leaders from the Puerto Rico legislature estimated this amount at $14 billion. These reports set the ball rolling on what will be the largest debt restructuring in the history of the municipal bond market.

We have our own views on the exact figures needed to put Puerto Rico back on the path to stability. Figuring out Puerto Rico’s true financial condition is more art than science. Investors have been left to guesswork, as the most recent audited financials available are for fiscal year 2013 (however unaudited figures have been made available in various press releases and bond offering documents). We will walk readers through our methodology.

There is between $2 billion and $3 billion in debt service coming due each year from 2016 to 2020.

We arrive at revenues of $9.4 billion for fiscal year 2015 by summing all line items, ex-government grants, on the government’s statement of activities.[1] Another way to arrive at this figure, which we believe accurately reflects revenue available to pay debt service, is to reduce the Commonwealth’s total revenues of $15.7 billion in 2013 by the $6.5 billion in external revenues received from the federal government. This is a conservative assumption because government grants from the U.S. Federal government can only be used for nondiscretionary earmarks such as Medicaid, and not debt service. We are left with $9.1 billion or so of revenues that could feasibly be used to pay the Commonwealth’s debt service. These revenues secure the Commonwealth’s tax-backed and appropriation-backed debt.

Since the Governor seems to be going in the direction of restructuring those entities separately as arms-length businesses, we treat them as separate. If you’ll recall, for example, the Puerto Rico Electric Power Authority is engaged with its creditors on a plan to restructure its $8 billion or so in long-term debt with a securitization of new power revenues and distressed exchange equal to 85% of par value.

Based on our analysis of the Commonwealth’s financials itself, tax revenues are sufficient to cover upcoming debt service payments by 2x to 4x each year. This is where the subject of “willingness” versus “ability” to pay comes in. The average state in the United States of America pays out 15% of its tax revenues in interest expense; Puerto Rico pays out 25%. If you include debt repayment, the figure increases to 45%. Another way of putting this is, $0.45 cents of every tax dollar collected is spent on services provided in the past, services paid for with debt. This is politically very challenging to sell to the people of Puerto Rico, especially when cuts to education and healthcare expenditures have been made to pay for ever-increasing levels of debt service. Members of the governor’s administration and both chambers of the Puerto Rico legislature will not let this happen.

We estimate the Commonwealth’s financing gap to be between $2.5 billion to $3 billion annually, pushing its five-year cumulative deficit to $12.5 to $15 billion, larger than both Krueger and working group estimates. To bridge this financing gap out of debt service, we estimate at most a 35%, across-the-board impairment to Puerto Rico general obligation and tax-backed debt, without further cuts to education and other discretionary services.

The market reaction to the release of these reports has been mixed. Below, we graph the price movements in bellwether Puerto Rico General Obligation 8% bonds due 2035 on their release dates. The market response to the Krueger report and PREPA’s Ad Hoc Creditor Group statements has been positive because of the lower than-anticipated impairments to creditors ranging from 15%-25%. The market reaction to the working group report impairments has been negative as bondholder losses in this report are more aggressive.


Determining an accurate forecast is difficult at best and impossible at worst. We think the restructuring is going to draw out over many years and may occur in Greek-like fashion where multiple agreements are signed in a patchwork approach over time. What we can say, however, is that buying insured Puerto Rico debt is a way to play on the market’s natural headline risk component. Bond insurer strength is high relative to their exposure, and leverage ratios are very modest compared to prior to the crisis. At Cumberland, we buy only insured Puerto Rico debt.

By the way, you can learn how to analyze state and local government debt in our new book, Adventures in Muniland: A Guide to Municipal Bond Investing in the Post-Crisis Era. You can purchase your copy by clicking here.

[1] The Statement of Activities accounts for the government’s income and expenses across related government agencies on a consolidated basis (separating out public corporation debt). For those unfamiliar with GASB accounting, this is an accrual-based summary of a nonprofit entity’s revenues and expenses, which loosely resembles a corporation’s income statement.

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