A Long Road Ahead for Puerto Rico

Transcription

1 A Long Road Ahead for Puerto Rico Market Commentary October 2017 PUERTO RICO IS STRUGGLING WITH THE IMPACT of being hit by two major hurricanes within just two weeks in mid-september. Hurricane Irma caused widespread power outages, while Hurricane Maria caused massive destruction. Much of the island remains without power or access to drinking water, and several hundred thousand homes have been lost. Even the most aggressive estimates suggest it will likely take months to restore power and basic utilities to most residents. We are thinking of those who have been displaced and continue to suffer the challenges of living without the most basic services or infrastructure. We recognize Puerto Rico s situation has dramatically changed from a financial to humanitarian crisis. Nevertheless, many open questions and unresolved issues remain for Puerto Rico s creditors. We believe these main factors will affect bondholders: Additional federal recovery dollars will likely be available later this year through multiple supplemental appropriation bills. Importantly, federal resources dedicated to rebuilding and recovery efforts will not be available for bondholders. Longer-term, the economic benefits of rebuilding could be viewed as benefitting creditor recoveries. Puerto Rico s capacity to pay debt is severely diminished in the short- to mediumterm. The longer-term economic capacity to service debt is unclear. A revised fiscal plan will provide an opportunity to reset expectations, and therefore reframe creditor negotiations. Recent events serve to validate the importance of the Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA), the Federal Oversight and Management Board (FOMB) and the Title III/bankruptcy process that was already in progress before the hurricanes. The board is likely to have an expanded role in administering federal aid. Bond prices fell precipitously in the weeks following the hurricane, and are unlikely to recover fully to trading levels prior to the storm. Municipal market participants will likely maintain a heightened focus on bond insurers, specifically their capacity to honor insured Puerto Rican debt and any ancillary effect on other insured bonds. Increasing politicization of Puerto Rico is already happening. We view this as inevitable, and negative for bondholders. Molly Shellhorn Vice President, Senior Research Analyst Nuveen Asset Management, LLC Leading the Way in Municipal Bonds Since 1898, Nuveen has been a pioneer in municipal bonds, helping to build lasting value for investors. This municipal bond heritage is reflected in the way Nuveen Asset Management manages portfolios today. * 119 years of experience 25 credit research analysts $130.8 billion in municipal bond AUM Through ongoing publications, the team is committed to helping investors understand today s pressing issues. * Nuveen, LLC traces its history back to Nuveen s asset management business was established in Nuveen Asset Management credit research analysts and municipal fixed income assets under management as of 9/30/17. NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE

2 Federal Dollars Will Likely Be Available Rebuilding Puerto Rico will be a long-term, multi-year effort. Though several damage estimates ranging from $45 billion to $90 billion have been released, we are still likely weeks away from a thorough and credible accounting of the damage. Puerto Rico s governor recently requested nearly $5 billion to fund rebuilding efforts through multiple agencies, beyond Federal Emergency Management Agency (FEMA) Disaster Relief Fund (DRF). The problematic combination of an antiquated and now collapsed power system and the logistical challenges of being an island will make this rebuilding especially difficult. All resources must be brought in by ship or air, which presents additional costs and non-traditional complications. The U.S. Army Corps of Engineers is expected to coordinate the rebuilding of much of Puerto Rico s electric infrastructure, including the entire power transmission and distribution system. Restoring power is the first priority before other projects can be addressed, and the government hopes to have power restored to 95% of the residents by the end of the year. In mid-october, Congress passed a $36.5 billion supplemental appropriation for FEMA, which includes an additional $18.7 billion for the DRF. This funding is available for all states affected by recent disasters. A much larger supplemental appropriation is expected to follow in December, once affected entities have better damage estimates. Of the initial $36.5 billion, $4.9 billion will be designated to provide loans to local governments that have lost significant revenue due to natural disasters. These loans are meant to provide immediate liquidity to fund essential services when an entity has experienced a significant loss of revenue due to a natural disaster. The bill includes new language that allows U.S. territories to be deemed to be a local government for this purpose, which allows Puerto Rico and United States Virgin Islands (USVI) to qualify. Historically, loans under this program have been eventually forgiven by the federal government, and Puerto Rico s loan may also be forgiven, several years out. Congress is expected to pass another substantial supplemental appropriation for disaster relief by the end of the year. This will provide funding for all affected states and territories through numerous federal agencies that will participate in rebuilding efforts. Firmer estimates of actual costs are still needed, but the aggregate aid provided could be in the tens of billions of dollars. This supplemental spending bill should have strong support, as so many states have been affected by natural disaster in the last few weeks. Having Florida, Texas, California, Puerto Rico and the U.S. Virgin Islands all in need of funding creates a broad base of political support, which makes passage likely. Rebuilding is Critical to the Economy The federal bankruptcy court overseeing Puerto Rico s Title III/bankruptcy proceedings will consider a motion filed by the Puerto Rican government asking the court to certify that federal disaster relief funds are not subject to any creditor or thirdparty claims and will be used solely for their intended purpose. The court is likely to agree the only appropriate and legal use of these funds will be for eligible costs under federal programs. We expect recovery and rebuilding expenses will be tightly controlled and eventually audited, and not available to fund bondholder recoveries. Both Democrats and Republicans in Washington, D.C. have already expressed great sensitivity to the idea that U.S. taxpayers would be funding a bailout of holders of Puerto Rican bonds. Still, a massive rebuilding effort subsidized by the federal government is a prerequisite to stabilize the economic and humanitarian crisis, and may eventually accrue to the benefit of all stakeholders. Billions of dollars of new infrastructure investment would improve the value and efficiency of utility and transportation systems, enhancing Puerto Rico s economic growth potential. It was unclear prior to the storm how capital investment would be funded, given the local government s overwhelming debt burden and lack of access to traditional lenders. A new power distribution and transmission system, roads, hospitals and schools should all be coming over the next several years. Much of this capital investment was needed prior to the storm. Post-hurricanes, much of it may be paid for with some form of federal funding. This anticipated spending could represent short-term stabilization from construction activity and an opportunity for Puerto Rico to restart. Outmigration Is a Primary Long-Term Economic Risk To the extent this funding creates long-term value, creditors would eventually benefit from future economic growth, as long as depopulation doesn t undermine the Commonwealth s growth potential. Prior to PROMESA, Puerto Rico proposed 2

3 using growth bonds to entice creditors to enter into consensual settlements. Such instruments could become part of the eventual restructuring, with creditors receiving varying payouts depending on the level of positive, long-term, economic impact Puerto Rico realizes from the rebuilding effort. Perhaps the top risk to rebuilding and recovery is the race against an accelerating outmigration of the most employable Puerto Ricans to the United States. Prior to the hurricanes, population loss was averaging about 2% per year, adding up to a more than 10% decline since Thousands of residents have already left the island, and multiple projections estimate the island could lose nearly half a million people, or about 14% of the population. Currently, more than 4 million Puerto Ricans live in the U.S., while 3.4 million live in Puerto Rico. The longer it takes to restore power, the more likely the tens of thousands of Puerto Ricans who left just prior to the storm or shortly thereafter will start making plans to stay in the U.S. permanently. The stabilized population level, as well as the new base income and employment levels, will be key metrics in estimating how the island s creditors can benefit from any longterm economic stimulus from Washington, D.C. Short-Term Debt Capacity Is Severely Diminished With only about 20% of the island having power more than one month after Hurricane Maria, economic activity and tax revenue collections have come to a halt. Puerto Rican officials have said that without additional funds from Congress, the government faces a total shutdown. All liquidity has been depleted providing direct emergency assistance. Taxes not collected during this period are unlikely to ever be recovered. The challenges of rebuilding and waiting for full restoration of power and water are likely to accelerate the pace of outmigration, further depleting Puerto Rico s tax base and future ability to support current debt levels. Stakeholders are now worried about depopulation, not merely a trend of low-grade outmigration. A large population loss would lead to a much smaller economy and reduced ability to generate tax revenue. Depopulation threatens to permanently erode Puerto Rico s tax base, demand for utilities and economic capacity. To the extent Puerto Rico s population of working age adults is depleted, future economic capacity and ability to pay debt will be impaired. Oversight Board Likely Expands its Role Before year end, Congress is expected to consider several amendments to strengthen and clarify the role of the oversight board. Congressional hearings will discuss the oversight board s appropriate role following the storms. The impetus for expanding the board s authority is two-fold. First, there appears to be broad consensus that PROMESA must be expanded to ensure the board is in control of administering federal aid. Managing the recovery spending promises to be a complex and arduous undertaking, and it is unclear whether the Puerto Rican government has the institutional or administrative capacity to be successful. Additionally, it will be much easier to build Congressional support for funding if members are reassured the funds will be properly allocated in compliance with federal guidelines. Having the board in control will bolster confidence in the rebuilding efforts and thus likely speed the release of critical aid dollars. Second, it became very clear earlier this year there was significant ambiguity about the board s authority to ensure the certified fiscal plan is properly implemented. In August 2017, Puerto Rico s governor refused to implement furlough days and pension reform measures called for in the fiscal plan. The board s only recourse was to sue him. If lengthy litigation is necessary to enforce compliance with the agreed upon fiscal plan, it s not clear the board will ever have the capacity to implement the reforms Puerto Rico needs to change its current trajectory. The oversight board withdrew the lawsuit in early October following the catastrophic storms, but this summer s dispute over implementing the fiscal plan made the current ambiguity very obvious. We expect the oversight board s role and authority to be significantly expanded by year end. Bond Prices Are Unlikely to Recover Bond prices across all of Puerto Rico s security pledges moved sharply lower in the weeks following the hurricanes and are now trading at new lows. While visiting the island in early October, President Trump said Puerto Rico s debt would need to be wiped out. These remarks were the catalyst the Puerto Rico bond market needed to more realistically reflect the likely effect of Hurricane Maria on recovery rates as part of the PROMESA process. As the extent of devastation has become clearer and support for the debt restructuring process solidified, bond prices 3

4 across Puerto Rico s capital structure have dropped. Bond prices for general obligation (GO) bonds have not yet found a floor, trading as low as $26 as of late October. Prior to the storm, legacy GO debt was trading at $58. After the storm, trading volume in GO 8% coupon bonds issued in 2014 increased more than 10 times, from $83 million in the 30 days before the storm to nearly $1 billion since the storm. More than $8 billion in bonds have traded across all Puerto Rico security pledges in October, a higher volume than any month since Puerto Rico had already defaulted on most of its debt, but we now project the horizon for payment deferral has likely been extended for a much longer period of time. The Puerto Rican government and oversight board s focus will appropriately be on recovery, rebuilding and revising the fiscal plan. This reprioritization will push creditor negotiations further out into next year. Political, economic and legal uncertainty surrounding Puerto Rican bonds highlights the downside risks and will likely keep current prices depressed. Focus Will Heighten on Bond Insurers The three primary municipal bond insurers have significant exposure to Puerto Rico across all security pledges, ranging between $8.2 billion for Assured Guaranty to $9.6 billion for Ambac. Insured bond prices have held up comparatively well, but are still down approximately 4% to 6%, depending on the specific bond structures and insurer. Given that the underlying Puerto Rican bonds are generally down in the neighborhood of 50%, this 4% to 6% decline in insured Puerto Rican bond prices demonstrates the value of the insurance policy itself in a distressed credit situation. However, as a more severe debt impairment than previously anticipated becomes more likely in a large exposure name, heightened attention will be paid to the insurers claims paying resources (availability of funds to pay claims) and their respective abilities to withstand significant haircuts. If Puerto Rican bond pricing does not rise significantly from current levels, this could cause a material weakening in the perceived value of insurance. If the insurers ability to withstand more realistic stress tests falls short, the value of bond insurance could be questioned, leading to reduced confidence and potential downward rating actions. Each insurer s exposure varies by the specific security pledges they insure. Assured Guaranty has the greatest concentration of GO bonds, but also has significant exposure to the Puerto Rico Highway and Transportation Authority (PRHTA) and the Puerto Rico Electric Power Authority (PREPA). National s exposure is concentrated in the sales tax corporation (COFINA), PREPA and PRHTA. In contrast, over 75% of Ambac s exposure is to COFINA, with very little exposure to GO debt. Absent a negotiated settlement or consensual agreement, the payment priority dispute between GO and COFINA sales tax will likely be appealed all the way to the U.S. Supreme Court. This will take years of litigation and extend the period of non-payment. To the extent the magnitude of losses varies significantly by credit, the outcome for each insurer shifts. To be more specific, we believe it is useful to look at each insurer s Puerto Rican bond exposure, implied loss given current market prices, claims-paying resources and other insured municipal bond debt. Unrealistically high assumptions about Puerto Rican bond recoveries may obscure an accurate assessment of the insurers ability to withstand losses on hundreds of billions of dollars worth of exposure to other insured municipal bonds. Undoubtedly, a longer workout horizon is beneficial, as the insured book of business amortizes faster than new business is written. Current insured bond prices may not yet reflect the effect of potential losses, regardless of whether the ultimate restructuring is negotiated or courtmandated, one year or three years away, or dependent on a future growth bond. Increasing Politicization Is Negative for Bondholders In the face of a true humanitarian disaster and what promises to be an epic rebuilding effort, debt repayment is sure to fall further down the priority list for several stakeholders. As such, creditors are increasingly likely to become the casualty of several opposing political constituencies, which could result in much lower-thananticipated recovery values. There are clear constituencies for the local population, rebuilding and restoration of critical services and infrastructure, and a strong Congressional sentiment to avoid a federal bailout. Creditors were already being characterized as predatory vultures prior to the hurricanes. Post-catastrophe, any creditor arguing Puerto Rico still has the ability and obligation to pay debt service will be seen even more unsympathetically. This sentiment, combined with Congress not wanting to be seen 4

5 as bailing out the territory s profligate behavior over the last decade, threatens to make bondholders everyone s scapegoat. We do not see a strong constituency for making creditors whole outside of the creditors themselves. This dynamic existed before the storms and resulted in PROMESA in Following the recent hurricanes, these sentiments will strengthen, creating greater momentum for debt impairment. Preserving hope for future market access is unlikely to be an argument strong enough to compel debt service payments over payrolls, pension payments and services for citizens. This becomes even more certain as federal dollars become Puerto Rico s new source of capital. Puerto Rico has less need for the municipal bond market and traditional investors than it did prior to the storm. Up to this point, municipal investors have focused on relative recoveries within the 26 different indentures issued by the Commonwealth and its authorities. GO debt versus the COFINA sales tax pledge exemplifies this dynamic, as these prominent indentures rely on the same economic base. Given the magnitude of what has occurred, other priorities must also be considered when estimating future recoveries. The recent bond price action clearly reveals that some major bondholders have just started to look at a bigger picture and ask additional questions: The local economy may eventually stabilize, but at what level? Population will shrink by what amount? How will government employee and retiree pensions be funded? What will be the future repayment schedules of the impending massive federal loans be, if any? These questions must be carefully considered when thinking about longer-term recoveries. It is generally overlooked that Puerto Rico s government payrolls and pensions are two important sources of income for the population of the Commonwealth. Absent federal government support, the local government would run out of funds to meet payroll by the end of October. The Commonwealth s pension is on the cusp of pay-as-you-go status. Given the political situations locally and in Washington, D.C., it is highly likely that both pensions and payrolls will be met on a priority basis for the foreseeable future, even in the absence of any debt service payments. If we see loans from the federal government, distinct from what is already proposed, we should assume the repayment terms will also be senior to existing bonded debts, pushing existing bond recovery terms even further into the future. These payroll, pension and federal loan repayment priorities could easily relegate the prioritization of existing claims, making this look like more of an academic exercise a decade down the road. The first fiscal plan certified by the oversight board earlier this year provided resources to support only 24% of aggregate debt service over the initial 10-year period. The board will revise the fiscal plan in the near term, and we expect it to reflect the recovery costs, population loss and resulting reduction in expected future economic activity. The revised fiscal plan is likely to be even more unkind to creditors. We expect recent events will serve to build even more pressure for debt relief, so as to speed the island s economic recovery. 5

6 For more information, please contact your financial advisor or visit nuveen.com. SOURCES Hunter College CUNY, Estimates of Post-Hurricane Maria Exodus from Puerto Rico, Center for Puerto Rican Studies, October Office of the Governor of Puerto Rico, Governor of Puerto Rico Ricardo Rosselló s letter to Congressional leadership, October 7, 2017 Reorg Research Puerto Rico coverage El Nuevo Dia, Debate on the role of the Board after Maria, October 18, CNN interview Governor of Puerto Rico Ricardo Rosselló, October 19, 2017 El Nuevo Dia, Liquidity in the hands of Congress, October 12, Credit Sights, AGO/MBI/AMBC; Puerto Rico Stress Tests Post Maria, October 11, 2017 Bloomberg, Puerto Rico Governor s Dire Warning: Millions May Flee the Island, October 3, campaign=socialflow-organic&utm_source=twitter&utm_medium=social Reuters, Evacuees leave Puerto Rico by cruise ship, some doubting they will return, September 28, eanthem:+trending+content&utm_content=59cddf0b04d30173ca95f2d5&utm_ medium=trueanthem&utm_source=twitter Wall Street Journal, Bond Funds Dump Puerto Rico, October 25, 2017 Moody s Investors Service, Damage from Hurricanes Irma and Maria poses a challenge to credit quality, October 2, 2017 Moody s Investors Service, Commonwealth of Puerto Rico, Update: Moody s Downgrades Puerto Rico GOs, COFINA and Other Debt After Hurricane Maria; Outlook Negative, October 11, 2017 El Nuevo Dia, 95% with electricity before Christmas, October 15, 2017 El Nuevo Dia, Proposal to amend PROMESA law, October 22, 2017 U.S. Department of Defense, DoD News, Power Restoration in Puerto Rico Could Take Up to a Year, Corps Chief Says, October 20th 2017 EMMA This material is not intended to be a recommendation or investment advice, does not constitute a solicitation to buy or sell securities, and is not provided in a fiduciary capacity. The information provided does not take into account the specific objectives or circumstances of any particular investor, or suggest any specific course of action. Investment decisions should be made based on an investor s objectives and circumstances and in consultation with his or her advisors. A WORD ON RISK Investing involves risk; principal loss is possible. Debt or fixed income securities are subject to market risk, credit risk, interest rate risk, call risk, derivatives risk, dollar roll transaction risk and income risk, including the possible loss of principal. The value of the portfolio will fluctuate based on the value of the underlying securities. As interest rates rise, bond prices fall. Below investment grade or high yield debt securities are subject to liquidity risk and heightened credit risk. Foreign investments involve additional risks, including currency fluctuation, political and economic instability, lack of liquidity and differing legal and accounting standards. Clients should contact their tax advisor regarding the suitability of tax-exempt investments in their portfolio. If sold prior to maturity, municipal securities are subject to gain/losses based on the level of interest rates, market conditions and the credit quality of the issuer. Income may be subject to the alternative minimum tax (AMT) and/or state and local taxes, based on state of residence. Income from municipal bonds held by a portfolio could be declared taxable because of unfavorable changes in tax laws, adverse interpretations by the Internal Revenue Service or state tax authorities, or noncompliant conduct of a bond issuer. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager. This material is for informational and educational purposes only and is not intended to be relied upon as investment advice or recommendations, does not constitute a solicitation to buy or sell securities and should not be considered specific legal, investment or tax advice. This information represents the opinion of Nuveen Asset Management, LLC and is not intended to be a forecast of future events and this is no guarantee of any future result. Information was obtained from third party sources which we believe to be reliable but are not guaranteed as to their accuracy or completeness. There is no assurance that an investment will provide positive performance over any period of time. Nuveen Asset Management, LLC, a registered investment adviser, is an affiliate of Nuveen, LLC. GPE-NPRMAR-1017P INV-AN-10/18 Nuveen 333 West Wacker Drive Chicago, IL nuveen.com