Municipal Brief. Puerto Rico Market Update 8 May begin on page 8.

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1 Puerto Rico Market Update 8 May 2017 Wealth Management Research Thomas McLoughlin, Head Americas Fixed Income, thomas.mcloughlin@ubs.com; Kristin Stephens, Senior Municipal Strategist Americas, kristin.stephens@ubs.com; Paul Jacobson, Municipal Strategist Americas, paul.jacobson@ubs.com On 3 May 2017, the Financial Oversight and Management Board for Puerto Rico (the "Oversight Board") filed a petition with the US District Court for the District of Puerto Rico on behalf of the Commonwealth to restructure its general governmental debt under Title III of the Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA). The filing marks the largest debt restructuring in the history of the municipal bond market and forces another hold on litigation in the wake of the 1 May 2017 expiration of the PROMESA stay. The action affects debt issued by the government, along with that of various agencies and public corporations, as shown in Fig. 2. US Supreme Court Justice John G. Roberts, Jr. appointed US District Judge Laura Taylor Swain of the Federal District Court in Lower Manhattan to preside over the case on 5 May. We believe the court proceedings will be very time consuming and could last anywhere between months. Also on 5 May, the Oversight Board announced that it had approved and certified the filing in the same court of a petition under Title III of PROMESA for the Puerto Rico Sales Tax Financing Corporation (COFINA). The action halts lawsuits by COFINA creditors, as well. Bondholders should not expect to receive any coupon payments on general governmental debt during the course of the proceedings. While COFINA's next debt service payment due on 1 August 2017 could be paid by money that has already been set aside with the bond trustee, the risk that this will not occur has increased as a result of the filing, in our view. Separately, Puerto Rico Governor Ricardo Rosselló Nevares stated at a press conference that the Commonwealth intends to pay no more than 24% of its debt due through FY26 as stipulated by the certified fiscal plan. In the wake of the 3 May filing announcement, Puerto Rico's benchmark general obligation (GO) bond (8% coupon due in 2035) saw the most activity, exchanging hands at a price of around USD 64-65, which is generally in line with the prior level. 1 On 3 May 2017, the Oversight Board filed a voluntary petition for relief on behalf of the Commonwealth of Puerto Rico pursuant to the Puerto Rico Oversight, Management, and Economic Stability Act This report has been prepared by UBS Financial Services Inc. (UBS FS). Analyst certification and required disclosures begin on page 8.

2 (PROMESA or "the Act"). The petition was filed pursuant to Title III of the Act in the United States District Court for the District of Puerto Rico (the "Court"). The Oversight Board petitioned that the same relief apply to the Puerto Rico Sales Tax Financing Corporation (COFINA) two days later. In both instances, the Commonwealth expressed its intent to continue to negotiate with bondholders toward consensual agreements while this process is underway. Title III authorizes Puerto Rico to restructure its debt after good faith efforts to reach a consensual agreement with creditors have failed. In order to file under Title III, the Commonwealth and/or its instrumentalities must first receive approval from the Oversight Board, which has been granted. Second, the Court must be satisfied that the following conditions have been met before the case can proceed to trial: The entity must be the Commonwealth of Puerto Rico or one of its instrumentalities; The Oversight Board has issued a certification of such an entity; The entity desires to restructure; Prior to the restructuring proposal, the Oversight Board certified that the entity made good faith efforts to reach a 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; The fiscal plan for the entity is in place; and A qualifying modification under Title VI is not in place. The market must now await the District Court's evaluation of the petitions to ascertain whether obligations to engage creditors and meet other preconditions have been satisfied. In its petition to the Court on behalf of the Commonwealth for voluntary relief, the Oversight Board stated that the Puerto Rico economy has contracted nine out of the last ten years and that population continues to decline. Based on current and projected revenue, the Oversight Board believes that the Commonwealth and its instrumentalities cannot satisfy their collective USD 74bn of outstanding debt and USD 49bn of pension liabilities while simultaneously paying operating expenses. It also confirmed that the three main pension systems are projected to deplete their liquid assets between July and December of The petition states that the Commonwealth lacks sufficient resources to protect the health, safety, and welfare of the people of Puerto Rico. 2 A plan of adjustment under Title III would consider both outstanding debt and the pension liability. CIO WM Research 8 May

3 We believe that the Court will find conditions warrant the cases proceeding to trial, but there is no guarantee this will occur. PROMESA authorizes the Chief Justice of the United States, John G. Roberts, Jr., to appoint a presiding judge to oversee any litigation arising from Title III. He selected US District Judge Laura Taylor Swain of the Federal District Court in Lower Manhattan on 5 May. It is in her discretion to hold the proceedings in Manhattan or in federal court in San Juan. Judge Swain has an extensive background in bankruptcy law and has handled a number of prominent financial cases in recent years, including a lengthy criminal trial of several former employees of Bernard Madoff and SAC Capital Advisors' insider trading case. What to expect next By our count, there are currently 22 lawsuits underway where creditors are demanding payment or seeking a stay on other actions taken by the Commonwealth to intercept revenue pledged to bondholders. We believe the Title III petition will consolidate the debt restructuring process for each issuer into a single case and supersede other lawsuits. The Commonwealth's certified fiscal plan, approved by the Oversight Board on 13 March 2017, provides the initial operating framework under which the Court must proceed at trial. COFINA is included among the covered entities under that plan. Pursuant to Section 305 of PROMESA, the Title III judge is prohibited from adjusting the certified fiscal plan without the Oversight Board s approval. To wit, Governor Rosselló stated at a recent press conference that the government intends to pay no more than 24% of its debt due through FY26 as provided under the plan. As a practical matter, the judge may be able to exert pressure on the Oversight Board to alter certain aspects of the plan. That said, it will be up to the Oversight Board to suggest a plan of debt adjustment to the Title III judge at trial. Creditors are expected to argue the legal merits of the plan's treatment of each individual class of bondholders. The Title III process is untested and Puerto Rico's various bond security liens and other liabilities are highly complex. If we use the Detroit (MI) and San Bernardino (CA) bankruptcies as a guide, bondholders should prepare for legal proceedings to last anywhere between 24 and 48 months. We are obliged to note that there is a high degree of uncertainty to this estimate, which we may regularly revise as developments unfold. We do not expect the Commonwealth or its agencies to make debt service payments in the interim, with the exception of payments made from any remaining monies on hand in reserve funds. While COFINA's next debt service payment due on 1 August 2017 could also be paid from funds already set aside with the bond trustee, the risk that this will not occur has increased as a result of the filing, in our view. We expect there to be no disruption in the payment of any Puerto Rico bonds insured by Assured Guaranty or National Public Finance Guarantee as a result of the recent developments, excepting for any modest procedural delays. Fig. 1: City of Detroit and City of San Bernardino timeline City of Detroit Filed for bankruptcy on 19 July 2013 Bankruptcy eligibility trial commenced on 28 October 2013 Bankruptcy eligibility decision on 3 December 2013 Bankruptcy trial commenced on 2 September 2014 Bankruptcy trial concluded on 27 October 2014 Bankruptcy reorg plan approved by the Court on 7 November 2014 Emerged from bankruptcy on 10 December 2014 City of San Bernardino Filed for bankruptcy on 1 August 2012 Bankruptcy eligibility trial commenced on 21 December 2012 Bankruptcy eligibility decision on 28 August 2013 Bankruptcy confirmation approved by the Court on 7 February 2017 Formal emergence from bankruptcy expected in spring 2017 Source: UBS, as of 4 May 2017 CIO WM Research 8 May

4 Corporate bankruptcies follow an established pattern whereby ample precedent exists upon which to estimate recovery values. Municipal bankruptcy law is still evolving, however, and often results in unexpected outcomes. 3 Title III of PROMESA is a novel and untested statute. We believe Puerto Rico's debt restructuring will be treated in a manner closer to municipal than to corporate bankruptcy petitions, but PROMESA's limited applicability to federal territories suggests that the process may still differ in meaningful ways from the proceedings in Detroit and San Bernardino. In Detroit's case, from an initial bankruptcy petition filing on 19 July 2013 to the emergence from bankruptcy protection on 10 December 2014, a total of 509 days had passed a full 1 year, 4 months, and 21 days. The short duration of Detroit's actual court case reflects months of creditor negotiations leading up to the bankruptcy trial and the active participation of the bankruptcy judge assigned to the case, which together resulted in numerous consensual negotiated settlements. The City of San Bernardino filed for bankruptcy protection on 1 August 2012 and, as of today, has not yet officially exited. At present, this duration totals 1,740 days (4 years, 9 months, 6 days and counting). Given the far greater complexity of Puerto Rico's capital structure, we believe that its creditor disputes will take a significant amount of time to resolve (see Fig. 1). Affected entities The 3 May petition affects the debt issued by the Commonwealth of Puerto Rico as well as that of various agencies and public corporations. We show the largest of these borrowers by debt outstanding in Fig. 2. The subsequent 5 May filing ensured the Puerto Rico Sales Tax Financing Corporation (COFINA) was included. A petition under Title III has not presently been filed for the Puerto Rico Electric Power Authority (PREPA), the Puerto Rico Aqueduct and Sewer Authority (PRASA), or the Puerto Rico Children's Trust, the issuer of the territory's tobacco settlement revenue bonds. These entities have outstanding debt in the amounts of USD 8.96bn, USD 3.89bn (senior lien), and USD 1.15bn, respectively. Rating agency response Moody's, S&P, and Fitch each published some brief commentary following the announcement on 3 May. Fitch indicated that it did not plan to change its ratings of the Commonwealth. 4 Moody's posited that Title III should "help establish an orderly framework to address competing creditor claims and those of pensioners, leading to higher overall bondholder recoveries." 5 Even so, it expressed concern that the process is unlikely to be quick or easy. Fig. 2: Impacted debt by Title III filing Debt Outstanding (USD bns) Commonwealth of Puerto Rico (GO) and Puerto Rico Public Building Authority (Commonwealth Guaranteed) Sales Tax Financing Corporation senior lien 7.58 Sales Tax Financing Corporation subordinate lien 9.72 Puerto Rico Highways and Transportation Authority (HTA) 1968 Resolution bonds Resolution bonds 3.50 Government Development Bank of Puerto Rico (GDB) 4.13 Puerto Rico Employees Retirement System (ERS) 3.16 Puerto Rico Infrastructure Financing Authority (PRIFA) (rum tax) 1.78 Puerto Rico Public Finance Corporation (PFC) 1.20 Puerto Rico Municipal Finance Agency (MFA) 0.62 University of Puerto Rico (UPR) 0.50 Puerto Rico Convention Center District Authority (CCDA) 0.39 Puerto Rico Industrial Development Corporation (PRIDCO) 0.16 Note: Of this group, MFA and the HTA 1968 resolution bonds are not currently in default. PRIDCO, UPR, ERS, HTA 1998 resolution bonds, and CCDA have not yet missed a payment but are drawing on reserve funds for debt repayment. ERS and HTA are likely to default on 1 July 2017, with reserves having been exhausted by that time. All other obligors are in default.cofina is not currently in default. Sales taxes already remitted to the trustee are sufficient to make the 1 August debt service payment. The certified fiscal plan provides for no further sales tax payments to the trustee when the required set-asides begin again on 1 July. Source: Moody's, UBS, as of 6 May 2017 S&P determined that the filing would likely have little effect on its taxbacked ratings of the Commonwealth, in light of those ratings already being either 'D' (default) or 'CC' with a negative outlook (suggesting near certainty of default). 6 The rating agency observed that while there may be no rating impact, creditor recovery rates will probably become even more uncertain. CIO WM Research 8 May

5 Market update The price of senior lien COFINA bonds and legacy Puerto Rico GOs held steady at approximately USD 60 on the 3 May filing announcement (see Fig. 4). 7 Over the past 30 days, subordinate lien COFINA bonds witnessed price erosion of approximately 10 points (see Fig. 4). 8 We attribute this to a confluence of factors, the largest being that the certified fiscal plan includes sales tax revenue dedicated to COFINA as an available resource, as well as a restructuring offer released publicly by the Puerto Rico Fiscal Agency and Financial Advisory Authority (FAFAA) on 24 April The proposal treated senior and subordinate lien COFINA bonds equally, receiving 39.3% recovery through new 30-year, back-loaded amortization, 'senior bonds,' along with a 'cash flow bond' that would be paid only upon performance in excess of the certified plan. The zero-coupon cash flow note is valued to increase overall recovery by a further 18.8%, for a theoretical aggregate COFINA recovery of 58.1% that we believe is unlikely to be realized. GO and GO-guaranteed bonds would recover 52.4% on senior notes, with another 25% in cash flow bonds, that could be worthless. A counterproposal to GO and guaranteed bondholders dated 1 May then offered to exchange 70% of legacy debt into a 5%, 30-year senior bond and another 20% into a similarly structured cash flow vehicle. The failure to arrive at any agreements here preceded, and possibly precipitated, the Title III filings. Fig. 4: Select credits and price trends of Puerto Rico municipal bonds /16/2015 1/16/2016 3/16/2016 5/16/2016 7/16/2016 9/16/ /16/2016 1/16/2017 3/16/2017 COFINA Snr Lien Puerto Rico GO COFINA Sub Lien Source: Bloomberg L.P., UBS, as of 8 May 2017 A lapsed deadline and four more fiscal plans Governor Rosselló was obliged to submit to the Oversight Board a proposed budget, a detailed implementation plan for the measures contained in the certified fiscal plan, and a revised liquidity plan by 30 April As we go to press, the Oversight Board has not publicly posted any documents suggesting that this deadline was met. The Board also posted several other important documents this month, including final fiscal plans for PRASA, HTA, GDB, and PREPA, all of which it approved and certified as in compliance with PROMESA. We review some highlights below. GDB's fiscal plan calls for the gradual and orderly runoff of the bank. Most loans owed by the central government and other public corporations are assumed uncollectible and written off. Creditors are split almost evenly between depositors and bondholders, and there is insufficient cash flow to meet debt service requirements on senior unsecured debt. The HTA plan considers separating the long-underperforming Tren Urbano from the Authority and a toll credit monetization to increase revenue. Cash flow is insufficient for debt service even after fiscal measures are implemented in light of ongoing clawbacks of operating revenue for the benefit of the central government. PRASA's plan seeks a moderate, but broad-based, multi-year rate increase for industrial, commercial, and government customers to finance operating expenses, debt service, and its capital improvement program. A funding gap remains, even when assuming the imple- CIO WM Research 8 May

6 mentation of various fiscal measures, which PRASA seeks to address through consensual negotiations with creditors. The certified plan calls for a 35% reduction in PRASA's debt service payments over the next ten years. The focus of PREPA's plan is on achieving lower generation costs and capturing other efficiency gains. The utility has already negotiated a restructuring support agreement (RSA) with a majority of creditors that would facilitate a debt restructuring, if finalized. The plan shows that PREPA is cash flow positive upon implementation of the RSA. After numerous extensions, that agreement is now scheduled to expire on 1 September Conclusion Puerto Rico's announcement comes as little surprise, but nonetheless represents a historic and record debt restructuring for the municipal bond market. In light of this being such a widely anticipated event, we do not expect there to be any immediate contagion effects for other stateside municipal borrowers. There could be some continued residual impact on bonds issued by other US territories, however, and specifically the US Virgin Islands which already is experiencing its own version of fiscal and economic crisis. For Puerto Rico bondholders, the outlook is discouraging. The Title III process is unprecedented and there is no clear sense as to timing. Judge Swain is highly experienced; however, she is taking on an enormous and unenviable task. Investors should not expect any debt service payments to be made while Title III is underway, with the possible exceptions previously noted for COFINA and any bonds still drawing on reserve funds a bit longer for debt repayment. Governor Rosselló seeks to pay only the amount specified in the certified fiscal plan - 24% of what is owed across all governmental debt - for the next ten years. Longer term, steep losses and extensions across the debt stack are likely. Some credits may see only nominal recoveries depending on how the process unfolds. Bond prices suggest that there is not much upside at current levels. Please refer to our Puerto Rico Credit & Market Update dated 18 April 2017 for more information regarding the Commonwealth's certified, ten-year fiscal plan, an explanation of why Puerto Rico's benchmark general obligation (GO) bond (the 8% coupon due in 2035) trades at a price of approximately USD 65, and further background on PROMESA's debt restructuring process. CIO WM Research 8 May

7 End notes 1 On 5 May 2017, USD 1mn of Puerto Rico GO 8% coupon bonds due in 2035 traded at a price of USD 65. This institutional-sized transaction established a Bloomberg BVAL price of USD at the opening on 5 May Please refer to Notice of Filing of Statement of Oversight Board in connection with PROMESA Title III Petition, pages See UBS, Municipal Market Guide, 14 July 2016, and Municipal Market Guide, 14 November Fitch, "Puerto Rico's ratings unchanged by Title III bankruptcy filing," 5 May Moody's, Issuer Comment, "Puerto Rico (Commonwealth of): Federal Oversight Board starts judicial process to restructure general obligation debt," 4 May S&P, "Bulletin: Puerto Rico PROMESA Title III filing unlikely to have an impact on Commonwealth ratings," 3 May Trade history is based on Bloomberg BVAL pricing. 8 Trade history is based on Bloomberg BVAL pricing between 4 April 2017 and 4 May CIO WM Research 8 May

8 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 ve s t m e n t G ra d e N on Ī n ve s t m e n t G ra 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. 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 8 May

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