Municipal Brief. Puerto Rico Credit & Market Update 18 April 2017

Transcription

1 Puerto Rico Credit & Market Update 18 April 2017 Wealth Management Research Thomas McLoughlin, Head Americas Fixed Income, Kristin Stephens, Senior Municipal Strategist Americas, Paul Jacobson, Municipal Strategist Americas, On 13 March, the Financial Oversight and Management Board for Puerto Rico (the "FOMB" or the "Oversight Board") certified the Commonwealth's 10-year fiscal plan, which now becomes the broad operating framework within which Puerto Rico must develop budgets going forward. Prices on Puerto Rico general government bonds broadly declined in response. The plan, which incorporates less optimistic economic and revenue projections than initially envisioned, has been critiqued for opacity on certain assumptions. It also proposes to repay only 23.5% of debt service between June 2017 and 2026, and does not differentiate as to how various types of debt would be treated in this event. Creditor groups viewed this as a violation of the requirements set forth under the Puerto Rico Oversight, Management, and Economic Stability Act ("PROMESA" or the "Act"). We continue to anticipate losses across the debt stack, regardless of security pledge. Litigation between general obligation ("GO") and Puerto Rico Sales Tax Financing Corporation ("COFINA") bondholders was halted by a 20 March appellate court ruling. With the Congressionally-imposed stay on litigation expiring on 1 May, and consensual debt negotiations expected to begin only this month, the likelihood of negotiated resolutions on this and other complex claims is low. Although the Commonwealth and the FOMB had petitioned to extend the stay, there are no indications that Congress is prepared to comply with that request. The Rosselló Administration sought, and tentatively obtained, further concessions under a revised Restructuring Support Agreement ("RSA") between forbearing creditors and the Puerto Rico Electric Power Authority ("PREPA"). Uninsured PREPA bonds rallied on the news. Moody's lowered ratings across an assortment of Puerto Rico credits this month and revised the rating outlook to negative from developing. The rating actions were attributed to a perceived diminished capacity for repayment. A certified fiscal plan On Monday, 13 March, the Financial Oversight and Management Board for Puerto Rico (the "FOMB" or the "Oversight Board") certified the Commonwealth of Puerto Rico's 10-year fiscal plan. The plan This report has been prepared by UBS Financial Services Inc. (UBS FS). Analyst certification and required disclosures begin on page 13.

2 is based upon certain assumptions regarding economic growth, population, and available cash flow for debt repayment. The Board's certification was provided after some delay, and only after the FOMB rejected the original plan submitted by Governor Ricardo Rosselló Nevares on 28 February. While the initial version had been criticized for the use of revenue assumptions that were overly optimistic, the certified plan is predicated upon more challenging economic and growth assumptions. Interestingly enough, it incorporates an optimistic estimate of population loss. To the extent that population decline matches or exceeds the rate we have witnessed recently, the financial results are likely to be worse than forecast. In the absence of any corrective action, the certified plan estimates a cumulative financing gap of USD bn from FYs The budget deficit declines to approximately USD 32bn if debt service payments of USD bn are excluded (USD bn- USD bn = USD bn). 1 To the extent that the Rosselló Administration is able to implement an aggregate USD 40bn of revenue and spending measures, which is by no means assured, the government is still left with approximately USD 8bn of remaining funds for the payment of debt service (USD 40bn of budget adjustments - USD 32bn deficit = USD 8bn remaining available for debt service). On 27 March, creditors and bond insurers sent a joint letter to the FOMB outlining their thoughts on some of the shortcomings of the certified plan and how it stands in violation of PROMESA. The fiscal plan does not differentiate as to how available funds for debt service would be allocated across the eighteen different types of debt included in the restructuring proposal. There is no clarity on the prioritization of the payment of principal over interest, for example, or senior lien relative to subordinate lien debt. The plan also fails to account for approximately USD 49bn of reported net pension liabilities. Implementation risk is high, in our view, and could necessitate further debt service haircuts. We reiterate our expectation that bondholders will see losses across the full debt stack, regardless of the security pledge. The degree of complexity and uncertainty that faces bondholders is high. A stay on creditor litigation is scheduled to expire on 1 May and consensual debt negotiations are expected to begin only this month. We believe the complexity of competing claims, and the limited time available in which to address them, increases the likelihood that these matters will be resolved in federal court under Title III of PROMESA. We discuss the differences between PROMESA Title III and Title VI in more detail in an Appendix to this report. Although the Commonwealth and the FOMB have petitioned to extend the stay, the probability of this occurring is low, in our view. The Congress is in the midst of a two week recess, and is preoccupied by other legislative initiatives. A sharper economic contraction The more severe economic contraction, now forecasted in the certified plan, is largely unexplained. Governor Rosselló's original plan CIO WM Research 18 April

3 was more optimistic. We believe that reductions in the size and budgeted expenditures of the Puerto Rico government, as well as the possible loss of future dollars from Washington, may be responsible for the downward revision. The certified plan also may have been intentionally designed to forecast economic growth conservatively, and thus revenue collection, going forward. This would increase the likelihood of plan benchmarks being met, and establish a lower bar from which to begin debt restructuring negotiations. As shown in Fig. 1, GNP in the certified plan is anticipated to continue to contract through 2021, with 2022 the first year of sustained economic growth. If we align these projections with the legacy Government Development Bank ("GDB") of Puerto Rico's Economic Activity Index ("EAI"), the Commonwealth will have experienced nearly 15 years of economic contraction. We believe that the shift in its economy will have lasting changes and consequences. Fiscal plan incorporates only a 0.2% yearly population decline Puerto Rico's certified fiscal plan presupposes a 0.2% yearly population decline between 2017 and 2026, an important assumption that underpins many other economic and revenue projections. Based on the actual trend of population decline on the island, we view the forecast as optimistic, at best. The plan offers little insight into how this estimate was formulated. Fig. 1: Projected annual GNP growth 3% 2% 1% 0% -1% -2% -3% -4% Certified plan Proposed plan Source: Puerto Rico Fiscal Agency and Financial Authority (AAFAF), UBS, as of 13 April 2017 Puerto Rico's population fell 0.85% in 2016, 4.25 times the assumed rate of loss in the certified plan (-0.85 / = 4.25x). The last time Puerto Rico experienced a population decline of 0.2% or less was in 2005 at %, based on data released by the now non-operational GDB (see Fig. 2). On a trailing 16-year basis, the island's average annual population loss has been -0.34%, a full 14bps higher than forecast in the certified plan. The US Census Bureau estimates that between 2025 and 2050, Puerto Rico's population will decline at an average annual rate of 0.59%. Fig. 2: Puerto Rico historical and projected annual population declines 0.4% 0.0% -0.4% -0.8% -1.2% -1.6% Historical Proposed plan's projection US Census Bureau's projection Note: US Census Bureau projection is the average annual projected decline from Source: US Census Bureau, Puerto Rico Fiscal Agency and Financial Authority (AAFAF), UBS, as of 12 April 2017 CIO WM Research 18 April

4 An unsustainable debt burden In the debt sustainability section of the certified plan, Puerto Rico would repay approximately 23.5% of contractual debt service owed by various government agencies between June 2017 and 2026 (see Fig. 3). 2 This amount is USD 3.4bn lower than provided in the prior proposal. The plan does not describe when bondholders might expect to receive these payments, nor does it provide for the eventual repayment of past due amounts at some time after Next steps for the FOMB Following adoption of the certified fiscal plan, the FOMB also voted for the Commonwealth to submit a detailed budget and a revised liquidity plan by 30 April. The latter must recommend solutions to generate a USD 200mn cash reserve by 30 June 2017 (see Fig. 4). Separately, the FOMB announced the appointment of Natalie Jaresko as its Executive Director on 23 March. Ms. Jaresko served as the minister of finance for Ukraine during its debt restructuring. Fig. 3: Debt sustainability analysis In USD millions yr avg. Baseline projections Revenues 18,952 17,511 16,407 16,434 16,494 16,590 16,746 16,953 17,204 17,509 17,080 Expenses (17,872) (18,981) (19,233) (19,512) (19,950) (20,477) (20,884) (21,310) (21,973) (22,316) (20,251) Surplus / (deficit) excluding debt service 1,080 (1,470) (2,826) (3,078) (3,456) (3,887) (4,138) (4,357) (4,769) (4,807) (3,171) Proposed measures Revenue enhancements ,381 1,384 1,531 1,633 1,740 1,752 1,766 1,785 1,390 Expense reductions (262) 951 2,012 2,415 2,983 3,156 3,255 3,619 3,724 3,830 2,568 Total (262) 1,875 3,393 3,799 4,514 4,789 4,995 5,371 5,490 5,615 3,958 Recovery analyis Proposed funds available for debt service , , Required debt service 3,283 3,283 3,828 3,453 3,437 3,171 3,063 3,475 3,003 3,329 3,333 Estimated recovery value* Note: Recovery values assume all Commonwealth of Puerto Rico debt at parity and is expressed in USD per 1USD. Source: Puerto Rico Fiscal Agency and Financial Authority (AAFAF), UBS, as of 12 April 2017 Fig. 4: Budget certification time line As per PROMESA Section March: Set timeline for budget certification per PROMESA 202(a) and work with Oversight Board in designing a reporting structure and forms 14 April: Adopt procedures to deliver timely public statements per PROMESA 202(a) 22 May: Submit revised budgets and supporting documents to Board, if necessary March April May June 30 June: Last day for budget certification per PROMESA 202(e) July 13 March: Certification of Fiscal Plan 28 April: Submit budget and implementation plan Stay on litigation expires on 1 May 5 June: Budget certification FY18 begins on 1 July Source: Puerto Rico Fiscal Agency and Financial Authority (AAFAF), UBS, as of 12 April 2017 CIO WM Research 18 April

5 Lex Claims litigation With so little revenue allocated to bondholders under the fiscal plan, we remain attuned to developments in the ongoing dispute between GO and COFINA bondholders. While the GO bonds began defaulting in July 2016, COFINA bonds continued to be paid as scheduled.go bondholders sued to invalidate the COFINA structure and divert pledged sales tax revenue for GO debt repayment in October 2015 (Lex Claims, LLC, et. al. v. The Commonwealth of Puerto Rico, et. al., in the US District Court for the District of Puerto Rico). COFINA bondholders, meanwhile, have asserted their contractual rights to the same revenue stream and seek to have the USD 3bn March 2014 GO bond offering declared unconstitutional. The case was stayed until 1 May by the federal US Court of Appeals for the First Circuit on 20 March, in line with the expiration of the broader stay on litigation required by PROMESA. In the absence of a negotiated solution, we expect Lex Claims to be heard by the US District Court for the District of Puerto Rico and subsequently appealed to the First Circuit in Boston. Fig. 5: Pricing on Puerto Rico GO vs. COFINA senior-lien bonds Price, in USD Dec-15 Feb-16 Apr-16 Jun-16 Aug-16 Oct-16 Dec-16 Feb-17 Apr-17 COFINA Snr Lien Puerto Rico GO Source: Bloomberg, UBS, as of 12 April On this basis, ultimate resolution of the dispute could take time. Market pricing indicates that Puerto Rico GOs and senior lien COFINA bonds continue to trade at, or near, parity. In our view, this reflects investors not having strong conviction on the outcome of the case, or perhaps that they expect a similar loss for each type of security (see Fig. 5). We expect the bonds to continue to trade in this range until a court decision is rendered. Without further clarity, we believe GO and COFINA bondholders dependent on cash-flow should conservatively prepare for 1-10 years of abridged payments. 3 For now, based on deposits made into the COFINA trust year-to-date, we continue to believe that sufficient revenue has been set aside to cover full coupon payments for senior and subordinate lien COFINA bonds in FY17. The next such payment is due in August. PREPA back at the negotiating table Declaring that the previously negotiated Restructuring Support Agreement ("RSA") between forbearing creditors and the Puerto Rico Electric Power Authority ("PREPA") was "not transformational enough," the Rosselló Administration sought and obtained further concessions in a revised preliminary agreement released 6 April. The agreement was originally scheduled to be finalized on 13 April but, as we go to press, no further updates were available. The RSA is the only consensual restructuring agreement that Puerto Rico or its debtissuing instrumentalities have reached with creditors to date. Uninsured PREPA bonds rallied broadly on the news, with light trading. PREPA 5.00% coupon bonds due in 2042, the most actively traded PREPA security, improved in price from approximately USD on 6 April to USD 71 by 12 April, an increase of 10.4% (see Fig. 6). 4 Under the previous RSA, an ad hoc group of uninsured bondholders (less USD 700mn par) agreed to a 15% principal haircut, lower coupon payments, and a five-year payment moratorium. In exchange, Fig. 6: PREPA 5s of 2042 Price, in USD Dec-15 Feb-16 Apr-16 Jun-16 Aug-16 Oct-16 Dec-16 Feb-17 Apr-17 Source: Bloomberg, UBS, as of 12 April 2017 CIO WM Research 18 April

6 they would have received new securitization bonds to be issued by a bankruptcy-remote entity created under the PREPA Revitalization Act, the PREPA Revitalization Corporation ("PREPA-RC"). The revised RSA, now under discussion, appears to be premised upon the following terms: A 15% haircut for uninsured bonds, which would be exchanged for tax-exempt securitized bonds at a ratio of 85%; Securitized bonds accompanied by either a 4.75% coupon if the investor selects the current interest rate bond (CIB) option, or a 5.50% coupon for capital appreciation bonds (CABs); 5 Final maturity of all of restructured bonds extended to 1 July 2047, with both the CIBs and CABs having a 10-year call; Restructured bonds no longer required to have an investment grade rating for the RSA to close, but this condition remains a post-closing requirement; 6 Non-RSA signatories would presumably be compelled to participate in the RSA through implementation of Title III of PROMESA; and Elimination of Options C and D under the original RSA. 7,8 Debt restructuring under the RSA still hinges upon court validation and the creation of PREPA-RC. Until that new legal entity is created and subsequently validated, the debt restructuring cannot occur even if the Oversight Board allows the RSA to proceed. It is possible that the Puerto Rico Supreme Court will eventually render the final opinion on this matter. We believe court validation could occur in mid to late Moody's strikes again Moody's lowered the ratings across an assortment of Puerto Rico credits and revised the rating outlook to negative from developing on 5 April. The rating actions were attributed to a perceived diminished capacity for repayment. The following securities saw their rating decline from Ca to C as a result: (i) GDB senior notes; (ii) Employees Retirement System pension obligation bonds; (iii) Puerto Rico Infrastructure Finance Authority bonds secured by federal rum tax transfer payments; (iv) Convention Center District Authority hotel occupancy tax bonds; and (v) Puerto Rico Highways and Transportation Authority 1998 resolution bonds. Simultaneously, the rating on the Puerto Rico Industrial Development Company's commercial property rent-secured bonds was lowered to Ca from Caa3. Moody's believes that each of these securities faces more severe losses than it previously had expected. The rating agency continues to maintain a higher rating of Caa3 on Commonwealth GO and guaranteed debt, and on revenue bonds issued by COFINA, the Puerto Rico Aqueduct and Sewer Authority ("PRASA"), and PREPA. Moody's revised the rating outlook on the power utility to negative from developing on 6 April. In its view, the modified RSA "introduces additional risk and uncertainty to the execution of a final consensual agreement." CIO WM Research 18 April

7 Market update Puerto Rico debt declined rather dramatically in price following the release of the certified fiscal plan. For example, as shown in Fig. 7, the Commonwealth's benchmark GOs, the 8.00% coupon bonds due in 2035, lost approximately 12.3% of their value since the beginning of March (from USD to USD 64.65). 9 Subordinate lien COFINA bonds carrying a 5.25% coupon due in 2041 fell from USD to USD 38.73, or 18.3%, over the same timeframe. 10 Meanwhile, the price of senior lien COFINA bonds weakened by 9.6%, with a 5.25% coupon bond due in 2040 moving from USD to USD (see Fig. 8). 11 We believe there are a number of reasons why the Commonwealth's benchmark GO bonds trade at a price of approximately USD 65. First, the 8s of 2035 are considered to be an "on-the-run" security, in municipal parlance. This means that the bond is the most recently issued cusip, is held in the hands of predominately institutional investors, has the largest par amount outstanding, and trades more frequently. It is considered, by far, to be the most liquid in the Puerto Rico GO market. Fig. 7: Price trends, Puerto Rico GO 8.00% due 1 July 2035 Last price in USD Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 Dec-16 Jan-17 Feb-17 Mar-17 Apr-17 Note: Puerto Rico GO 8.00% 2035 were issued at USD on 11 March Source: MSRB trade data, Bloomberg, UBS, as of 12 April Puerto Rico's legacy GO bonds would be considered "off-the-run" securities, by contrast. These bonds are more widely held by retail investors and mutual funds that have had Puerto Rico exposure for many years; holders that are less likely to trade their positions. The legacy bonds, despite having the same legal claim, have a lower dollar price and trade less frequently. 12 Fig. 8: Select credits and price trends of Puerto Rico municipal bonds Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 Dec-16 Jan-17 Feb-17 Mar-17 Apr-17 Sales Tax Financing Corporation subordinate lien Puerto Rico Electric Power Authority Puerto Rico General Obligation Sales Tax Financing Corporation senior lien Puerto Rico Aqueduct and Sewer Authority Source: MSRB trade data, Bloomberg, UBS, as of 12 April CIO WM Research 18 April

8 Over time, we expect Puerto Rico's benchmark and legacy GO debt to more broadly converge in price, irrespective of coupon and/or maturity, comparable to the trading pattern observed in mid-2016 (see Fig. 9). For now, however, we expect elevated price volatility across Puerto Rico's securities as we near the next phase of the Commonwealth's eventual debt restructuring, either through a consensual agreement or in more adversarial court proceedings. So why are defaulted GO bonds still trading at USD 65? Volatility and internal rate of return ("IRR") support current trading levels. 13 Although the GO bonds are in default, they do have a constitutional claim and first lien on available revenue. The precise definition of "available revenue" will be contested, of course, but the GO bondholders are better positioned than many other creditors. Fig. 9: Puerto Rico GO price comparison, 8s of 2035 vs. 5s of 2041 Price, in USD Dec-15 Feb-16 Apr-16 Jun-16 Aug-16 Oct-16 Dec-16 Feb-17 Apr-17 Puerto Rico GO Puerto Rico GO Source: Bloomberg, UBS, as of 12 April 2017 On the downside, GO bondholders are striving to protect themselves under a worst case scenario. For example, if a buyer of Puerto Rico GO 8s of 2035 were to purchase the securities today at USD 65, and we assume that bond maturity is extended 10 years to 2045 in a restructuring, coupon is reduced by 66% (from 8% to 2.72%), and principal is lowered by 50%, the purchaser would receive an IRR of 1.15% per year if the restructured bonds are held to maturity (see Fig. 10). Fig. 10: Potential restructured cash flow for Puerto Rico GO 8s of 2035 Purchase price USD 65 Restructured cash flow illustration (100 bonds) Restructured maturity 7/1/2045 Date Principal Interest Lost cash flow Restructured coupon 2.72% 4/13/ ,000-1,733 Principal recovery 50% 7/1/ ,000 Estimated IRR 1.15% 7/1/ ,000 7/1/ ,000 7/1/ ,000 7/1/ ,000 7/1/ ,000 7/1/ ,000 7/1/ ,000 7/1/ ,000 7/1/2026-2,720 5,280 7/1/2027-2,720 5,280 7/1/2028-2,720 5,280 7/1/2029-2,720 5,280 7/1/2030-2,720 5,280 7/1/2031-2,720 5,280 7/1/2032-2,720 5,280 7/1/2033-2,720 5,280 7/1/2034-2,720 5,280 7/1/2035-2,720 5,280 7/1/2036-2,720-7/1/2037-2,720-7/1/2038-2,720-7/1/2039-2,720-7/1/2040-2,720-7/1/2041-2,720-7/1/2042-2,720-7/1/2043-2,720-7/1/2044-2,720-7/1/ ,500 2, yrs nonpayment Note: Puerto Rico GO 8.00% of 2035 originally issued on 3/17/2014. Analysis is based on potential bond restructuring to mature on 7/1/2045 with 10 years non-payment (started on 1 July 2016) Source: UBS, as of 12 April 2017 CIO WM Research 18 April

9 We previously established that these securities have a high level of price volatility. On 14 March, their value declined by 7 points (from approximately USD to USD 66.93, or 7.61%) in one session following the adoption of the certified fiscal recovery plan. 14 Conversely, on good news, such as a favorable court development, the better liquidity exhibited by the 8s of '35 would likely result in a sharp upward price movement, allowing an institutional investor to quickly capture return on investment. Conclusion and outlook Puerto Rico's economy has been contracting despite an economic recovery elsewhere in the United States. The persistent recession has amounted to a lost decade for the island. Population loss continues and the probability of receiving substantial incremental financial assistance from Washington is low. The prior gubernatorial administration made little progress in its negotiations with creditors. The Puerto Rico Electric Power Authority had the financial capacity to restructure its debt expeditiously but it still took two years to reach an agreement. There is a negligible chance, in our view, the Commonwealth can execute subsequent agreements across the capital structure in a fraction of the time it took to do so for PREPA. The certified fiscal plan has some inconsistencies, in our view. It fails to reduce spending year-to-year and does not distinguish between essential and non-essential government services. The population estimates appear far too optimistic. There is no differentiation among various constitutional and statutory liens. The absence of precision may be purposeful, to encourage further negotiation and to extract concessions from institutional investors and bond insurers. We believe the risks associated with implementation of the certified plan are exceptionally high. Puerto Rico has been in discussions with its creditors for more than a year without making much headway. The likelihood of achieving broad-based consensual debt restructuring across a disparate group of creditors within a timeframe of approximately two weeks is exceedingly low. We expect subsequent litigation to be costly and protracted and for negotiations between creditors and the Commonwealth to become even more contentious over time, regardless of the outcome of the PREPA discussions. We anticipate that most of the island's outstanding debt will be restructured pursuant to Title III of PROMESA. Creditors are likely to contest the proceedings on the basis that the Commonwealth did not engage in good faith negotiations when there was time to do so. Conservatively, we believe that bondholders, excluding those with PREPA obligations where likely impairment has been negotiated separately, should prepare for 1 10 years of abridged payments on their holdings and significant losses on their investments. CIO WM Research 18 April

10 Appendix I PROMESA's debt restructuring process PROMESA provides two paths for Puerto Rico and its instrumentalities to restructure existing debt obligations: Title VI (voluntary) and Title III (Federal Court). Title VI provides the process for a voluntary negotiated settlement, while Title III permits the Federal Court to approve a plan submitted by the Commonwealth and/or one of its instrumentalities. Such plan would be binding even upon dissenting creditors. This option is available only after the entity has made good faith efforts to reach a consensual restructuring with creditors. Title VI (voluntary) Sections 601 and 104(i) of PROMESA provide a process for submission and approval of a voluntary agreement to modify contractual bond claims. This modification may be proposed by a debtor or by bondholders, which differs from bankruptcy court convention where only the debtor is permitted to submit proposals to the court. If proposed by the bondholders, the Oversight Board has the authority to accept the proposal on behalf of the debtor. The Oversight Board, together with debtor as issuer of the bonds, will separate each proposed modification into separate groups based on: At least one group per issuer; Secured bonds will be in separate groups; Separate groups will be established based on seniority for issuers with multiple series of bonds outstanding; and Separate groups will be established for bonds guaranteed by the Commonwealth. Proposed modifications must be accepted by no less than 50% of the outstanding principal amount of the affected bonds in the particular pool entitled to vote, and by two-thirds of the aggregate outstanding principal amount of bonds in such pool of those who actually vote, in order to be approved. Next, the Oversight Board must vote to certify the hypothetical debt restructuring proposal if it satisfies the conditions under section 104(i) of PROMESA. The proposed modification will not become effective for holders until an order approving the qualifying modification has been entered by federal district court. Only a federal court can abdicate contractual obligations. Modification of contractual debt obligations are binding on all holders, irrespective of if they have given consent or participated in the negotiations, as long as the required majorities of holders of the bonds and the issuer have consented to the modification. CIO WM Research 18 April

11 Title III (Federal Court) After getting approval from the Oversight Board, Puerto Rico and/or its instrumentalities may file a petition with the Federal district court seeking to restructure debt under Title III. This is similar to seeking bankruptcy protection under Chapter 9. The following conditions have to be satisfied for a case to proceed: The entity must be the Commonwealth of Puerto Rico or one of its instrumentalities; The Oversight Board issued a certification to such an entity; The entity desires to restructure; Prior to the restructuring proposal, the Oversight Board has certified that the entity made good faith efforts to reach consensual restructuring; The entity has taken steps to deliver timely audited financial statements and other information for an interested person to make an informed decision; A fiscal plan for the entity is in place; and A qualifying modification under Title VI is not in place. The federal district court may confirm a debt adjustment plan if it meets the following criteria: The plan complies with the provisions of the bankruptcy code made applicable under Title III of PROMESA; The plan complies with the provisions of PROMESA; The debtor is not prohibited by law from taking action necessary to carry out the plan; Any other legislative, regulatory, or electoral approvals are in place; The plan is determined to be in the best interest of creditors and feasible (with the best interest of creditors test determined as being better than any other non-bankruptcy alternatives available to creditors); and The plan is consistent with the fiscal plan approved by the Oversight Board. CIO WM Research 18 April

12 End notes 1 Through January 2017, the Commonwealth has missed USD 2.4bn of payments on these obligations. 2 The certified plan includes the following types of Commonwealth debt obligations in the restructuring proposal: GO, GOguaranteed, Puerto Rico Public Building Authority (PBA), COFINA, the Puerto Rico Highways and Transportation Authority (PRHTA), the Puerto Rico Infrastructure Financing Authority (PRIFA), Puerto Rico Convention Center District Authority (PRCCDA), Puerto Rico Public Finance Corporation (PFC), University of Puerto Rico (UPR), Puerto Rico Employees Retirement System (ERS), GDB, and Puerto Rico Industrial Development Corporation (PRIDCO). It explicitly excludes PREPA, the Puerto Rico Aqueduct and Sewer Authority (PRASA), the Puerto Rico Housing Finance Authority (HFA), Children's Trust, the Puerto Rico Industrial Investment Corporation, and municipality-related debt. 3 The funds for COFINA's 1 August 2017 debt service payment are currently held with the trustee. It is unknown at this time if those funds will be released to bondholders. Our base case assumption is for the payment to be made. 4 Bloomberg BVAL pricing, CUSIP: 74526QA28 5 Previous versions of the RSA gave coupon ranges for the CIB and CAB bonds. In this revised RSA proposal, these coupon payments are now fixed at 4.75% and 5.50% respectively. 6 The RSA proposal explicitly says the "Investment grade rating is no longer a condition to RSA closing; remains a condition post-closing." It is unclear to us what the RSA proposal language surrounding "post-closing" means. 7 Option C originally permitted PREPA to tender for bonds at an undisclosed price. 8 Option D originally allowed for no more than USD 700mn of uninsured legacy PREPA revenue bonds to remain outstanding. These legacy PREPA bondholders would have received their revenues under the pre-existing flow-of-funds under PREPA's indenture. 9 Bloomberg BVAL pricing (CUSIP: 74514LE86). 10 Bloomberg BVAL pricing (CUSIP: 74529JLM5). 11 Bloomberg BVAL pricing (CUSIP: 74529JNU5). 12 The Puerto Rico 8% coupon bonds due in 2035 (CUSIP: 74514LE86) have embedded in their indenture a provision that requires any legal proceeding regarding payment on these securities to be held in a New York State court venue. We believe that certain terms established under PROMESA supersede this provision; however, there is uncertainty as to the ultimate validity of this legal provision. If upheld, it raises the possibility that these securities could be treated as a separate creditor class in a debt restructuring scenario, with legal proceedings possibility held in duel locations. This is not our base-case assumption. 13 The internal rate of return (IRR) on an investment is the annualized effective compound return, or rate of return. In fixed income, the IRR is used as a proxy to calculate theoretical yield of an investment on defaulted or restructured securities. 14 Bloomberg BVAL price change between 13 and 14 March 2017 (CUSIP: 74514LE86). CIO WM Research 18 April

13 Appendix Analyst certification Each research analyst primarily responsible for the content of this research report, in whole or in part, certifies that with respect to each security or issuer that the analyst covered in this report: (1) all of the views expressed accurately reflect his or her personal views about those securities or issuers; and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by that research analyst in the research report. Statement of Risk Municipal bonds - Although historical default rates are very low, all municipal bonds carry credit risk, with the degree of risk largely following the particular bond s sector. Additionally, all municipal bonds feature valuation, return, and liquidity risk. Valuation tends to follow internal and external factors, including the level of interest rates, bond ratings, supply factors, and media reporting. These can be difficult or impossible to project accurately. Also, most municipal bonds are callable and/or subject to earlier than expected redemption, which can reduce an investor s total return. Because of the large number of municipal issuers and credit structures, not all bonds can be easily or quickly sold on the open market. Terms and Abbreviations Term / Abbreviation Description / Definition Term / Abbreviation Description / Definition GO General Obligation Bond TEY Taxable Equivalent Yield (tax free yield divided by 100 minus the marginal tax rate) MMD Municipal Market Data Rating Agencies Credit Ratings I n v e st m en t G ra d e N on Ī n ve s t m en t A1 A2 A3 Baa1 Baa2 Baa3 Ba1 Ba2 Ba3 B1 B2 B3 Caa1 Caa2 Caa3 Ca S&P Moody's Fitch/IBCA Definition AAA Aaa AAA Issuers have exceptionally strong credit quality. AAA is the best credit quality. AA+ AA AA- Aa1 Aa2 Aa3 AA+ AA AA- Issuers have very strong credit quality. A+ A A- BBB+ BBB BBB- BB+ BB BB- B+ B B- CCC+ CCC CCC- CC C A+ A A- BBB+ BBB BBB- BB+ BB BB- B+ B B- CCC+ CCC CCC- CC+ CC CC- Issuers have high credit quality. Issuers have adequate credit quality. This is the lowest Investment Grade category. Issuers have weak credit quality. This is the highest Speculative Grade category. Issuers have very weak credit quality. Issuers have extremely weak credit quality. Issuers have very high risk of default. G r a d e D C DDD Obligor failed to make payment on one or more of its financial commitments. this is the lowest quality of the Speculative Grade category. CIO WM Research 18 April

14 Appendix Disclaimer In certain countries UBS AG is referred to as UBS SA. This publication is for our clients information only and is not intended as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. It does not constitute a personal recommendation or take into account the particular investment objectives, financial situation and needs of any specific recipient. We recommend that recipients take financial and/or tax advice as to the implications of investing in any of the products mentioned herein. We do not provide tax advice. The analysis contained herein is based on numerous assumptions. Different assumptions could result in materially different results. 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