Municipal Brief. Puerto Rico Credit & Market Update 1 June begin on page 8.

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1 Puerto Rico Credit & Market Update 1 June 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 30 May, US District Judge Laura Taylor Swain blocked payments due to Puerto Rico Sales Tax Financing Corporation (COFINA) bondholders pending resolution of certain legal disputes. COFINA, which had yet to default on its debt service payments, is now expected to do so for the first time today. The June payment is relatively modest, at approximately USD 16mn. A more significant payment of roughly USD 278mn is due on 1 August. Separately on 30 May, it was announced at a hearing in federal court in New York that the Commonwealth would make a USD 13.9mn payment due on 1 June to pension obligation bondholders of the Employees Retirement System (ERS). While debt service owed on ERS bonds is expected to be paid this month, this could abruptly change going forward. Puerto Rico Governor Ricardo Rosselló Nevares presented his proposed FY18 general fund budget plan for the Commonwealth on 31 May. The congressionally approved Financial Oversight and Management Board for Puerto Rico (FOMB) has called for the Commonwealth to lower the amount it spends on the University of Puerto Rico (UPR) by about half. The proposed reduction has reportedly spurred student protests, school closures, and the resignation of key university leadership. Meanwhile, the accreditation of eight of the university's 11 campuses was put on probation last week. UPR historically has received about 80% of its funding from the central government. On 15 May, the Puerto Rico Government Development Bank (GDB) entered into a Restructuring Support Agreement (RSA) with creditors to restructure legacy debt by pledging specific loan collateral with an estimated face value of approximately USD 5.345bn. As discussed in the prior edition of our Puerto Rico Credit & Market Update (25 May 2017), Laura Taylor Swain, US District Judge of the US District Court of the Southern District of New York, had scheduled a hearing for 30 May 2017 to consider various claims on cash held on deposit with COFINA's bond trustee for the payment of debt service ahead of a 1 June interest payment. Her ruling halts the payment of This report has been prepared by UBS Financial Services Inc. (UBS FS). Analyst certification and required disclosures begin on page 8.

2 debt service on COFINA obligations for now. The money instead will be placed into escrow. Judge Swain stated that her goal was "keeping the money safe and intact" pending resolution of broader legal challenges. Separately, on 30 May, it was announced at a hearing in federal court in New York that the Commonwealth would make a USD 13.9mn payment due on 1 June to pension obligation bondholders of the Employees Retirement System (ERS). While debt service owed on ERS bonds is expected to be paid this month, this could abruptly change going forward. The ERS bonds are paid from, and secured by, statutorily required employer contributions made to the pension fund after 31 January The system had been steadily depleting the debt service reserve fund for bond repayment. We had previously anticipated that those reserve accounts would be exhausted by May. 2 On 21 May, the FOMB filed a Title III petition on behalf of the ERS with the US District Court for the District of Puerto Rico, contemporaneously with a petition for the Puerto Rico Highways and Transportation Authority (HTA). Puerto Rico Governor Ricardo Rosselló Nevares presented a USD 9.6bn FY18 general fund budget plan for the Commonwealth on 31 May. At this level, the budget is 6.3% larger than the prior year, but includes a 9.1% cut in general expenses to offset a pension payment of approximately USD 2bn as funding for the public retirement system transitions to a pay-as-you-go basis. Governor Rosselló communicated that the budget is largely in line with the revenue and expense guidelines established under the Commonwealth's certified fiscal plan. Given that the FOMB is empowered to approve its own budget for the Commonwealth if it does not agree with the one proposed by the government, adherence to the broad parameters set forth under the fiscal plan is of paramount importance. Governor Rosselló indicated that the general fund budget does not assign money for the payment of debt service, but that this will be considered as part of the consolidated budget, and is expected to be consistent with the roughly USD 400mn set aside for FY18 in the fiscal plan. That amount is equal to around 12% of the roughly USD 3.3bn in debt service owed. It has yet to be determined if the Commonwealth will begin redirecting sales tax revenue pledged to COFINA bondholders for the payment of general governmental expenses in the coming fiscal year, which begins on 1 July. Heretofore, those receipts were directed to the COFINA bond trustee to satisfy its annual debt service requirements prior to being made available for general purposes. Market update Two institutional-sized trades of subordinate lien COFINA bonds occurred in the wake of the announcement about COFINA. On 30 May, the securities traded at a price of approximately USD 26.50, suggesting the bonds were holding relatively steady in the wake of Judge CIO WM Research 1 June

3 Swain's ruling, albeit near historical lows. 3 There were no notable trades in senior lien COFINA bonds as we went to press (see Fig. 1). Secondary market trading of Puerto Rico bonds appears to have slowed significantly over the past several sessions. The market continues to digest the rulings and motions out of the federal court, as well as any data released by the FOMB. Turning to the Commonwealth's benchmark general obligation (GO) bonds with an 8% coupon due in 2035, the securities traded on 30 May at a price of USD 59.50, which is in line with recent levels and similarly stand at record lows (see Fig. 2). GDB RSA On 15 May, Governor Rosselló announced that the GDB had entered into an RSA with approximately 45% of bondholders. The RSA seeks to use Title VI of PROMESA to restructure legacy debt. As discussed in our Puerto Rico Credit & Market Update (18 April 2017), Title VI requires 50% participation from bondholders and a two-thirds vote of existing bondholders in favor of the RSA for any plan to be certified by the FOMB and the US District Court. The support of an additional 5% of bondholders is needed in order for the proposed RSA to proceed, via solicitation by the GDB. Fig. 2: Price trends, Puerto Rico GO 8.00% due 1 July 2035 Last price, in USD Jan-16 May-16 Sep-16 Jan-17 May-17 Note: Puerto Rico GO 8.00% 2035 were issued at USD on 11 March Source: MSRB trade data, Bloomberg, UBS, as of 31 May 2017 As per the RSA, a Special Purpose Vehicle (SPV) would be created, similar to that contemplated for the Puerto Rico Electric Power Authority (PREPA) under its RSA (see Puerto Rico Credit & Market Update, 5 October 2016), whereby loan collateral would be secured and flow directly to the bond trustee. The GDB RSA pledges certain portions of the bank's loan portfolio, including real estate assets, proceeds of certain public entity loans, and excess cash, less certain previously pledged assets, as collateral for the creation of three amortizing bonds: Tranches A, B, and C. Fig. 1: 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 May-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 31 May 2017 CIO WM Research 1 June

4 This would present an alternative, or work-around, to the stipulation under the Commonwealth's certified fiscal plan that calls for the repayment of no more than 24% of what is owed across all governmental debt over the next 10 years. The likelihood of a more favorable recovery on GDB obligations in comparison to other Puerto Rico credits that are better secured under the terms of their bond contract on this basis is low, in our view. There can only be so much money to go around when working around a 24% cap, and some credits may see only nominal recoveries depending on how the process unfolds. GDB creditors party to the RSA presumably believe that the value of the pledged collateral will exceed how they otherwise would be treated in a broader debt restructuring scenario. Under the terms of the RSA, Tranches A and B would be secured by a first lien on the issuer's assets, and structured with amortizing principal payments from available cash on a pari passu basis. Tranche C would be secured by a second lien on the asset pool and not entitled to principal payments until Tranches A and B are paid in full. Interest payments would be paid semiannually on all three tranches to the extent cash is sufficient (see Fig. 3). According to the RSA, existing GDB bondholders would be placed in Tranche C by default if they fail to indicate which tranche they have elected. This assumes the RSA is eventually certified and that election instructions, which would be sent to bondholders, are ignored. Legacy GDB debt The GDB's debt stack includes 17 separate bonds, with maturities between 2016 and 2026 with a total par value of USD 3.772bn (see Fig. 4). 4 These securities, plus one GDB senior guaranteed note, are included in our debt restructuring analysis. 5 GDB RSA loan portfolio collateral The GDB RSA pledges specific assets to bondholders as collateral, with a purported face value of USD 5.345bn (see Fig. 5). Upon our review of the RSA, we believe that the loan portfolio collateral is worth significantly less than face value. For example, the RSA values the Ruiz Soler Hospital at USD 2.47mn. It appears that this facility has been abandoned for a significant length of time and, to date, has not attracted any prospective buyers. Loans to public corporations and agencies carry a face value of USD 2.69bn under the RSA and account for approximately 50% of the pledged assets. The HTA, which is responsible for 63% of these loans, filed for Title III reorganization on 22 May. At this time, it is unknown where HTA loans due to the GDB will fall in the capital structure of that reorganization. The RSA appears to acknowledge the loan pool's various weaknesses. Schedule 9 of the agreement, entitled "Municipal Loan Portfolio Forecast," establishes a projected municipal loan interest and amortization schedule through 2040, which we believe is intended to simulate the structure of the hypothetical Tranche B securities. 6 As per Fig. 3: GDB proposed new bond structures Payment priority (amortization) Tranche A Tranche B Tranche C 1st 1st 2nd Exchange ratio 55% 60% 75% New coupon 7.50% 5.50% 3.50% Interest payment schedule Amortized principal Semi-annual Semi-annual Semi-annual Parity with Tranche B Parity with Tranche A Source: GDB RSA, UBS, as of 25 May 2017 Fig. 4: GDB debt stack In USD millions 1,200 1, Subordinate to Tranches A & B Principal Interest Source: GDB, UBS, as of 31 May 2017 Fig. 5: GDB collateral analysis RSA collateral Face value Est. recovery Approx. value Municipal loans 1,764 85% 1,499 Loans to public corporations and agencies 2,690 5% 134 Property 85 10% 8 Other collateral 448 5% 22 Loans with proceeds assigned to issuer 309 5% 15 Cash % 50 Total 5,346 1,728 Note: Values in USD millions; estimated recovery rates as per UBS estimates. Source: GSB RSA, UBS, as of 31 May 2017 CIO WM Research 1 June

5 the illustration, principal repayment stands at USD 1.728bn on this basis, although the RSA does not explain how this figure was established (see Fig. 6). We extrapolate that Schedule 9 is based upon a future cash flow that presumes the loan collateral is worth 32.3% of face value (USD 1,728,196,563 / USD 5,345,603,664 = 32.3%). This level of principal repayment correlates with an 85% estimated recovery on municipal loans, 5% recovery on loans to public corporations and agencies, 10% recovery on property, 5% recovery on other collateral, 5% recovery on loans with proceeds assigned to an issuer, and 100% recovery on cash, by our estimates. GDB recovery analysis Assuming the RSA closes successfully and applies exclusively to uninsured GDB bondholders, we believe that bondholders who select Tranche B would receive a new cash bond with a 1 July 2040 maturity with a theoretical recovery value of 45.8 cents per dollar. This presumes that the bond is structured with a turbo redemption provision that acts as a sinking fund redemption feature, allowing for periodic sinking fund payments, at par (see Fig. 6). 7 Please note, estimated recovery is different for each bondholder due to the differences among investors based on their individual purchase price, purchase date, time held, sale price, and discount rate. All of these factors are equally important when formulating a recovery value. It is important to stress that this should only be considered an estimate; actual recoveries could vary. Fig. 6: Tranche B GDB RSA cash-flow analysis Date Beginning balance Principal Interest 5/31/2017 1,728,105,366 7/1/2017 1,728,105, ,214,440 8,184,499 7/1/2018 1,621,890,926 98,184,680 44,602,000 7/1/2019 1,523,706,246 91,450,474 41,901,922 7/1/2020 1,432,255,772 89,828,260 39,387,034 7/1/2021 1,342,427,512 92,740,792 36,916,757 7/1/2022 1,249,686,720 94,699,545 34,366,385 7/1/2023 1,154,987,175 99,233,921 31,762,147 7/1/2024 1,055,753,254 99,166,886 29,033,214 7/1/ ,586, ,049,386 26,306,125 7/1/ ,536, ,259,525 23,527,267 7/1/ ,277,457 98,309,753 20,715,130 7/1/ ,967, ,493,693 18,011,612 7/1/ ,474,011 92,156,545 15,248,035 7/1/ ,317,466 91,760,588 12,713,730 7/1/ ,556,878 88,730,748 10,190,314 7/1/ ,826,130 79,593,318 7,750,219 7/1/ ,232,812 60,965,577 5,561,402 7/1/ ,267,235 51,369,836 3,884,849 7/1/ ,897,399 37,511,484 2,472,178 7/1/ ,385,915 25,445,904 1,440,613 7/1/ ,940,011 14,728, ,850 7/1/ ,211,643 11,222, ,820 7/1/ , ,546 27,209 7/1/ , ,871 3,351 Source: GDB RSA, UBS, as of 31 May 2017 We review the methodology that brought us to the 45.8% recovery rate below. Our conclusion is based upon the following assumptions: 1. The Municipal Loan Portfolio Forecast shown in Schedule 9 of the RSA represents the actual payment schedule on the exchange bond (Tranche B). The RSA lacks the detailed information needed for us to develop our own loan performance payment schedule. 2. The exchange occurs on 1 July When determining recovery, the present value (PV) of each cashflow payment under Schedule 9 of the RSA must be calculated. This requires the conversion of future dollars into today's dollars via discounted cash flow methodology. In the following example, the PV of semi-annual cash-flows on this theoretical bond are multiplied by the PV factor, or discount rate, of 5.50%, to give a PV of future cashflows. In our view, this analysis should incorporate a discount rate of 10 15% for a loan pool of this quality. However, as previously noted, Schedule 9 is based upon a future cash flow that presumes the loan collateral is worth 32.3% of face value (USD 1,728,196,563 / USD 5,345,603,664 = 32.3%). Since Schedule 9 assumes the loan portfolio collateral will ultimately perform at significantly less than face value, we elected to use the coupon rate of 5.50% as our discount rate to solve for the PV cash-flows on this theoretical bond. CIO WM Research 1 June

6 Once each PV cash-flow is calculated, these biennial payments are totaled between 2017 and 2040, to equal USD 1,728,196,563 (see Fig. 6). Given that the GDB had USD 3,772,977,000 in par value of debt outstanding prior to the restructuring, the theoretical recovery value through the debt exchange would be 45.8 cents per dollar (USD 1,728,196,563 / USD 3,772,977,000 = 45.8%), as shown in Fig. 7. GDB bonds rally Immediately following public release of the RSA, GDB obligations rallied by approximately 8 points. Based on Bloomberg BVAL pricing, GDB debt is currently priced at approximately 35 cents (see Fig. 8). Our analysis calls for a theoretical recovery value of 45.8 cents per dollar, by contrast. We attribute this 10-point discrepancy ( = 10.8) to several factors. First, further disclosure of the loan portfolio is necessary. Actual recovery could be substantially lower, depending on the performance of the loan portfolio. Second, the RSA must obtain the 50% bondholder threshold. Third, and most important, in our view, is that the RSA would have to withstand the likely legal challenges that may be raised by competing creditor groups that may argue that Puerto Rico should be tasked with addressing its debt stack holistically. For these three primary reasons, we believe a steep discount from our projected theoretical recovery value is warranted. Fig. 7: Tranche B GDB RSA recovery analysis Maturity 2040 Discount rate 5.50% PV of future cash-flows USD 1,728mn Principal outstanding USD 3,773mn Theoretical recovery rate 45.80% Source: GDB RSA, UBS, as of 31 May 2017 Fig. 8: Prices on select GDB bonds In USD Nov-15 Feb-16 May-16 Aug-16 Nov-16 Feb-17 May-17 Source: Bloomberg, UBS, as of 31 May 2017 Conclusions There has been no shortage of developments in recent days with respect to the largest debt restructuring in the history of the municipal bond market. COFINA is poised to default for the first time this week. Bondholders should also be prepared for the same outcome when a larger debt service payment comes due on 1 August. And, while debt service owed on ERS bonds is expected to be paid this month, this could abruptly change going forward. UPR appears to be struggling with an unprecedented level of unrest and discord. For GDB, a tentative plan for the exchange of legacy obligations is in place, but the hurdles for finalizing the agreement are high. If the RSA is successfully completed outside of Title III, other creditors may be more inclined to pursue similar solutions. The HTA presents a noteworthy example. Past initiatives have resulted in the privatization of select HTA assets. There is active debate as to whether remaining HTA assets could serve as a source of collateral for creditors in its own restructuring, or if this will be precluded by bond-specific considerations (i.e., much of the revenue pledged for repayment of HTA debt being subject to "claw back" for the repayment of GO bonds). The outcome of this debate could materially affect the price of HTA obligations, either positively or negatively, depending on the result. For now, trading in uninsured HTA debt has been limited. CIO WM Research 1 June

7 We will remain attuned as more details from Governor Rosselló's proposed FY18 budget become available, and any possible implications the budget announcement may present for broader Puerto Rico bond prices. Longer-term, investors should continue to anticipate steep losses and maturity extensions across the debt stack, regardless of security pledge. Endnotes 1 Our recovery analysis is fully contingent on the RSA closing successfully, and applies exclusively to uninsured bondholders. Estimated recovery is different for each bondholder due to the differences among investors based on their individual purchase price, purchase date, time held, sale price, and discount rate. All of these factors are equally important when formulating a recovery value. It is important to stress that the true recovery value is a client's sale price, and also that these are just estimates, actual recovery could vary. 2 See UBS CIO Wealth Management Research, Municipal Market Guide, 16 February Cusips: 74529JLM5 and 74529JHN8. 4 The GDB defaulted in 2016, which is why this maturity is still included in our analysis. 5 Cusips: CH6, CJ2, EN1, EP6, ET8, EU5, EX9, FB6, FC4, FD2, FE0, FF7, FH3, FK6, FM2, FN0, GG4 6 Based on the size of the interest payments, Schedule 9 appears most similar to Tranche B. The future payments for Tranches A, B and C will vary based on the future take-up on selected tranches if the RSA is adopted and on the future performance of the loan portfolio. 7 The turbo redemption feature avoids payment defaults if the loan pool is unable to adhere to a set schedule. CIO WM Research 1 June

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. Disclaimer of Liability - This may contain information obtained from third parties, including ratings from credit ratings agencies such as Standard & Poor's. Reproduction and distribution of third party content in any form is prohibited except with the prior written permission of the related third party. Third party content providers do not guarantee the accuracy, completeness, timeliness or availability of any information, including ratings, and are not responsible for any errors or omissions (negligent or otherwise), regardless of the cause, or for the results obtained from the use of such content. THIRD PARTY CONTENT PROVIDERS GIVE NO EXPRESS OR IMPLIED WARRANTIES, INCLUDING, BUT NOT LIMITED TO, ANY WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE. THIRD PARTY CONTENT PROVIDERS SHALL NOT BE LIABLE FOR ANY DIRECT, INDIRECT, INCIDENTAL, EXEMPLARY, COMPENSATORY, PUNITIVE, SPECIAL OR CONSEQUENTIAL DAMAGES, COSTS, EXPENSES, LEGAL FEES, OR LOSSES (INCLUDING LOST INCOME OR PROFITS AND OPPORTUNITY COSTS) IN CONNECTION WITH ANY USE OF THEIR CONTENT, INCLUDING RATINGS. Credit ratings are statements of opinions and are not statements of fact or recommendations to purchase, hold or sell securities. They do not address the suitability of securities or the suitability of securities for investment purposes, and should not be relied on as investment advice. 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 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 1 June

9 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. Other than disclosures relating to UBS AG, its subsidiaries and affiliates, all information expressed in this document were obtained from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to its accuracy or completeness. All information and opinions are current only as of the date of this report, and are subject to change without notice. This publication is not intended to be a complete statement or summary of the securities, markets or developments referred to in the report. Opinions may differ or be contrary to those expressed by other business areas or groups of UBS AG, its subsidiaries and affiliates. Research publications from Chief Investment Office Americas, Wealth Management (CIO Americas, WM), formerly known as CIO Wealth Management Research,are written by UBS Wealth Management and UBS Wealth Management Americas, Business Divisions of UBS AG (UBS) or an affiliate thereof (collectively, UBS). UBS Investment Research is written by UBS Investment Bank. Except for economic forecasts, the research process of CIO Americas, WM is independent of UBS Investment Research. As a consequence research methodologies applied and assumptions made by CIO Americas, WM and UBS Investment Research may differ, for example, in terms of investment horizon, model assumptions, and valuation methods. Therefore investment recommendations independently provided by the two UBS research organizations can be different. The analyst(s) responsible for the preparation of this report may interact with trading desk personnel, sales personnel and other constituencies for the purpose of gathering, synthesizing and interpreting market information. The compensation of the analyst(s) who prepared this report is determined exclusively by research management and senior management (not including investment banking). 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UBS Financial Services Inc. is not acting as a municipal advisor to any municipal entity or obligated person within the meaning of Section 15B of the Securities Exchange Act (the "Municipal Advisor Rule") and the opinions or views contained herein are not intended to be, and do not constitute, advice within the meaning of the Municipal Advisor Rule. Version as per May UBS specifically prohibits the redistribution or reproduction of this material in whole or in part without the prior written permission of UBS and UBS accepts no liability whatsoever for the actions of third parties in this respect. UBS The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved. CIO WM Research 1 June