Municipal Brief. Puerto Rico Credit & Market Update 5 October 2016

Transcription

1 Puerto Rico Credit & Market Update 5 October 2016 Wealth Management Research Thomas McLoughlin, analyst, thomas.mcloughlin@ubs.com; Kristin Stephens, Analyst, kristin.stephens@ubs.com; Paul Jacobson, strategist, paul.jacobson@ubs.com The Puerto Rico Financial Oversight and Management Board convened its first meeting in New York on 30 September. The seven member Board elected a chairman and requested a fiscal turnaround plan from Governor Alejandro García Padilla by 14 October. The Board also requested budget updates and cash flow reports. The Board announced that the central government, major public utilities, university, and Government Development Bank will be subject to the Board's oversight. Governor García urged the Board to focus its efforts on the island's public pension system, which is demonstrably insolvent. We believe that the Board will await the election of the next governor in November before taking any substantive action regarding the financial administration of the island. Additional defaults on Commonwealth general obligation bonds are likely in January, in our view. However, the government is still setting aside monthly sales tax receipts for the payment of bonds on the Puerto Rico Sales Tax Financing Corporation (COFINA, by its Spanish acronym), making a default on these bonds less likely. US District Court Judge Francisco Besosa refused to halt a lawsuit where creditors have challenged the government's moratorium on debt service payments. The oversight board steps in The Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA) was enacted on 30 June 2016 after extensive negotiations between the Obama Administration and the Congressional leadership. Among other provisions, PROMESA authorized the creation of a Financial Oversight and Management Board for Puerto Rico (the 'Board' or the 'Oversight Board') to preside over the territory's finances and restructuring negotiations with creditors. The Board is composed of seven members. Two individuals are nominated by the Speaker of the House and another two by the Majority Leader of the Senate. The minority leaders in both the House and the Senate each nominate one member. President Obama retains the discretion to appoint the seventh member. The president formally appointed the seven voting members of the Board on 31 August, ahead of a 15 September deadline set forth in This report has been prepared by UBS Financial Services Inc. (UBS FS). Analyst certification and required disclosures begin on page 16.

2 PROMESA. Not surprisingly, the Board's composition has been the subject of considerable scrutiny and partisan criticism. Please refer to Fig. 1 for the names of those individuals appointed to the Board and a description of their professional qualifications. Most board members have held prior positions in the public and private sectors, and have practical experience working with financial institutions. Messrs. García and José González, for example, each served as chairman of the Puerto Rico Government Development Bank (GDB) during prior gubernatorial administrations. Their prior affiliation with the GDB has created consternation among some observers concerned with conflicts of interest. While we understand the reasons for such concern, Puerto Rico's financial statements are exceptionally complex. On balance, the appointment of some Board members with prac-tical experience with the territory's financial practices and institutions strikes us as prudent. Meanwhile, the appointment of two academicians is a reflection of the dynamic tension between the rights of pensioners to receive their retirement benefit and the contractual rights of creditors to repayment in accordance with relevant statutes. David Skeel has supported the extension of bankruptcy law to state governments and territories. 1 Considering Puerto Rico's fiscal situation in early 2016, he concluded that "bankruptcy can solve these problems. It removes the risk that a debtor will pick and choose which obligations to pay, and it ensures that creditors' priorities will be honored." 2 Based on the outcome in Detroit, where capital market creditors were disproportionately penalized, we are less confident than is Professor Skeel that a bankruptcy court is the best answer for distressed governments. Andrew Biggs is known for his work in the area of Social Security reform. He also is an advocate for public pension reform, including the use of a risk-free rate of return on assets to calculate the unfunded liability. His appointment suggests that the Board will give careful consideration to the Commonwealth's massive unfunded pension liability. In a recent report, Moody's characterized this issue as likely being "the most crucial precedent to emerge from Puerto Rico's debt crisis." 3 The rating agency warned that if the oversight board "creates a federally sanctioned preference for unsecured pensions over bonded debt, it could have broad, negative implications for the credit quality of debt obligations of state and local governments." We agree. Fig. 1: Appointees to the Financial Oversight and Management Board for Puerto Rico Appointee Carlos García David Skeel, Jr. Andrew Biggs José Carrión III (Chair) Arthur Gonzalez José Ramón González Ana Matosantos Richard Ravitch Professional qualifications Former Puerto Rico Government Development Bank Chairman and former Santander Bank Senior Executive Professor at the University of Pennsylvania Law School and bankrupcy expert Resident scholar at the American Enterprise Institute, with expertise in pensions and entitlements Puerto Rico insurance executive; served as Chairman of Puerto Rico's Workers Compensation Board from 2009 to 2012 Former chief judge of the US Bankruptcy Court for the Southern District of New York. Oversaw Chrysler and Enron's Chapter 11 cases. President and CEO of the Federal Home Loan Bank of New York and former Puerto Rico Government Development Bank Chairman Former director of the California Department of Finance Non-voting member representing Governor García. Former New York Lieutenant Governor; pivotal figure in the fiscal stabilization of New York City in the 1970s; served as chairman of the New York Metropolitan Transportation Authority for many years. Note: José Carrión III, Carlos García, José Ramón González, and Ana Matosantos are native Puerto Ricans. Mr. Carrión is the brother-in-law of Resident Commissioner Pedro Pierluisi, Puerto Rico's representative to the US Congress. Source: The White House, UBS, as of 4 October Former New York Lieutenant Governor Richard Ravitch was named a non-voting member of the board by Puerto Rico Governor Alejandro García Padilla. Under the terms of the law, Governor García could have served in this capacity himself, or designate someone for this purpose. Mr. Ravitch has been advising the government on a pro bono basis with respect to its fiscal situation for some time. He was a pivotal figure in the stabilization of New York City during its fiscal crisis in the 1970s. He also served as chairman of the New York Metropolitan Transportation Authority for many years. The board's first meeting was held on the morning of 30 September in New York City. The agenda included the election of a chairperson, the CIO WM Research 5 October

3 adoption of bylaws, the initial designation of covered entities under the Act, and the commencement of a search for an executive director, among other administrative matters. Mr. Carrión was selected as chairman at the meeting. The Board also formally asked Governor García to submit a fiscal adjustment plan by 14 October. Governor García indicated in a televised address on 29 September that the Commonwealth would deliver a first draft of such a plan in about two weeks, followed by another draft in November that incorporates the board's recommendations, and a final plan before year-end. The Board expects to hold subsequent meetings in mid-october and mid-november. Upcoming debt service payments With the exception of the Puerto Rico Sales Tax Financing Corporation (COFINA), most of the major Puerto Rico issuers have their largest debt service payments due in January and July. COFINA's largest semiannual debt service payment months are in February and August, by contrast. As described in our Municipal Brief, Puerto Rico Credit & Market Update (5 July 2016), Governor García declared a moratorium on the payment of general obligation debt service and the debt of certain other instrumentalities due on 1 July. This triggered sizable defaults on that date. We anticipate additional defaults on 1 January while the oversight board ramps up. For now, the Commonwealth continues to allow the pledged sales tax revenue to flow to the COFINA bond trustee. Once distributed to the trustee, the Commonwealth is unable to access the funds. S&P calculates that the trustee would likely have enough money on deposit to make full-year COFINA debt service payments through 1 August 2017 as long as sales tax distributions continue through the end of December. 4 S&P expects that payments made through the end of September 2016 will likely be sufficient to cover the 1 February 2017 interest payment on senior and subordinate COFINA debt, and that payments through December would cover the rest of the year through August. The agency's forecast is based on the provisions of the bond indenture, which mandate the capture all pledged revenue in each fiscal year beginning 1 July until enough cash has been collected to make full principal and interest payments due on the next succeeding 1 February and 1 August. 5 Approximately USD 708.5mn in debt service is due for the bond year, according to the rating agency, and is almost entirely interest given COFINA's heavily back-loaded and ascending debt service schedule. Approximately USD 241mn of FY17 sales tax was distributed to the COFINA bond trustee through August In comparison, an interest payment of roughly USD 345mn is due on 1 February, net of federal subsidies, and USD 120mn per month of pledged sales tax revenue has been available historically. CIO WM Research 5 October

4 We believe the rating agency's analysis to be a reasonable one, having performed our own independent review (please see Appendix I: A focus on COFINA, for more detail). Based on the results of our analysis, pledged sales tax revenue distributed to the COFINA trust is already sufficient for the payment of senior lien debt service in FY17; however, an additional USD 467mn of sales tax revenue must be collected in this fiscal year before the same can be said about COFINA's subordinate lien bonds. If payments continue to flow to the COFINA trust in the coming months, we would expect prices on 2017 maturity subordinate lien COFINA bonds to improve. COFINA investors appear to be better positioned than GO bondholders in the near-term. Longer-term, we believe that COFINA bonds are still at risk of being restructured, despite their relatively strong security provisions. COFINA represents a large component of the Commonwealth's overall debt stack, and its ascending debt service structure implies that it will be a growing area of budgetary pressure for the island over time. Creditors holding general obligation bonds are likely to argue that they cannot be expected to accept a haircut on their investment while holders of the sales tax revenue bonds are left unimpaired. Of course, the Commonwealth sales tax also represents the single best source of revenue with which to secure any future bond issue to restructure outstanding obligations or to fund infrastructure development. The Oversight Board inevitably must address the conflict between the holders of general obligation bonds and the holders of COFINA bonds. We believe that the subordinate lien sales tax revenue bonds are more exposed in the reorganization of the Commonwealth's debts. Litigation update In prior reports, we have reaffirmed our opinion that private investors should expect extensive litigation in the wake of each new default. The pace of litigation has indeed increased, despite PROMESA's explicit provision for a stay on legal proceedings filed against the government after 18 December 2015 through the later of 15 February 2017, or six months after the establishment of the Oversight Board. 6 The automatic stay remains in effect unless modified by the federal district court. Shortly after the appointment of oversight board members, Francisco Besosa, a federal judge for the US District Court for the District of Puerto Rico, refused to temporarily halt a lawsuit where bondholders challenge the governor's moratorium on debt service payments on selected bond issues. Among other complaints, the plaintiffs contend that the government has violated PROMESA by making payments that are junior in priority to the payment of the island's constitutional debt. They seek an injunction halting those payments. At the same time, the government of Puerto Rico argues that PROMESA prevents the creditors from bringing suit over the moratorium on the payment of debt service. Judge Besosa found on CIO WM Research 5 October

5 2 September that PROMESA's stay on litigation does not apply, thus allowing the case to proceed. Governor García has requested that the oversight board consider intervening in the trial. Intervening in any litigation filed against the island or its instrumentalities is among the powers of the oversight board. Election update Puerto Ricans will elect a new governor this November. There are two primary political parties on the island. Governor García, who is affiliated with the Popular Democratic Party (PDP), announced in December 2015 that he would not be running for re-election. David Bernier, his former secretary of state, was nominated as the party's candidate. Ricardo Rosselló Nevares is the New Progressive Party (NPP) candidate, having defeated Pedro Pierluisi in a closely-fought primary earlier this year. Rosselló is the son of a former Puerto Rico governor. We believe the island's debt restructuring plans will be deferred until the new gubernatorial administration takes office in January Fig. 2: Price trends, Puerto Rico GO 8.00% due 1 July 2035 year-to-date Last price in USD Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Note: Puerto Rico GO 8.00% 2035 were issued at USD on 11 March Source: MSRB trade data, Bloomberg, UBS, as of 3 October Puerto Rico prices edge higher Following the formal appointment of the oversight board on 31 August 2016, prices on the island's benchmark bonds initially improved before reversing course. For example, the price of the Commonwealth's benchmark general obligation bonds, the 8s of 2035, increased by 2 points to reach USD on 8 September before moving back down to hover near an all-time low (USD ) by the end of the month. Most recently, the benchmark bonds showed some modest price improvement based on a few smaller 100m trades (see Fig. 2). The bonds last traded at USD Shifting to the price behavior of other individual Puerto Rico related credits, generally speaking, prices have edged higher (see Fig. 3). Fig. 3: Select credits and price trends of Puerto Rico municipal bonds Jan-16 Feb-16 Mar-16 Apr-16 May-16 Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Sales Tax Financing Corporation subordinate lien Puerto Rico General Obligation Puerto Rico Aqueduct and Sewer Authority Source: MSRB trade data, Bloomberg, UBS, as of 3 October Puerto Rico Electric Power Authority Sales Tax Financing Corporation senior lien CIO WM Research 5 October

6 Compared to mid-may, the price on subordinate lien COFINA bonds carrying a 5.25% coupon and maturity date of 2043 increased to now trade in the low USD 50's (USD on 3 October) from the low USD 30's previously, as an example. At the same time, senior lien COFINA bonds, 5 1/4s due 2040, witnessed price improvement of almost 15 points (USD vs. USD in May). Also, we examined the price trend for bonds issued by the Puerto Rico Aqueduct and Sewer Authority (PRASA). This issuer's senior lien bonds carrying a 5.25% coupon and maturity date of 2042 last traded at USD 73.75, up from the high USD 50's in mid-may (USD 57.92). PREPA update The restructuring of Puerto Rico Electric Power Authority (PREPA) debt continues to move forward, albeit at a snail's pace. On 22 June 2016, the Puerto Rico Energy Commission (PREC) announced the approval of PREPA's request for an additional 3.1 cent per-kilowatt hour (kwh) non-bypassable surcharge on customer's monthly utility bills to cover debt service on future Special Purpose Vehicle (SPV) bonds that PREPA plans to issue through the Puerto Rico Electric Power Authority Revitalization Corp (PREPA-RC). See Fig. 4 for an illustration of how the SPV flow-of-funds will function. Two days later, PREC also approved a temporary increase in PREPA's base-rate that averaged cents per-kwh across customer classes. This is the first base-rate increase since The rate increase went into effect on 1 August 2016, and will remain in effect until the PREC concludes its review of PREPA's petition for rate review and a new rate schedule is drafted. According to PREC, this should occur in the first quarter of Together, these two separate rate increases will constitute a total increase of 4.4 cents per-kwh once a proposed Restructuring Support Agreement (RSA) between PREPA and certain of its largest creditors is implemented. According to PREPA's most recent monthly report to the Governing Board, dated June 2016, the utility has charged an average of cents per-kwh during fiscal year This 4.4 cents per-kwh would bring the total to cents, an average increase of 23.7%. Fig. 4: Proposed PREPA SPV flow-of-funds PREPA Customer SPV Charge Bond trustee (US Bank) Restructured bondholders Full bill payment Local Bank Remainder PREPA Remainder after operating expenses Legacy bondholders Source: PREPA, UBS, as of 4 October PREPA is using PROMESA's pre-existing voluntary provisions exemption to proceed with the RSA. 7 Furthermore, the power utility is currently in the process of seeking court validation to create PREPA- RC under the PREPA Revitalization Act and issue the SPV bonds. 8 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 Finally, on 21 September 2016, the Commonwealth of Puerto Rico experienced a widespread power outage after a fire occurred in a switch yard at the 900 megawatt Aguirre power plant, PREPA's largest generator. This fire was notable because Aguirre is the planned site for a future off-shore natural gas port, with the Aguirre facility itself being converted from fuel oil as the dominant source of power generation to natural gas. CIO WM Research 5 October

7 PREPA recovery analysis We have provided a theoretical recovery analysis for the RSA as Appendix II: A focus on PREPA. The first version of the RSA was announced in an EMMA filing on 22 July 2015, the product of nearly a year of earlier negotiations between the power utility and its largest creditors after entering into a bond forbearance agreement in August Since July 2015, the RSA has gone through several changes, with the most recent version, dated 30 June 2016, evaluated in this report. Our analysis is fully contingent on the RSA closing successfully, and applies exclusively to uninsured bondholders. We continue to believe PREPA bondholders holding debt that is insured by National Public Finance Guarantee and Assured Guaranty will be repaid in full on the basis of the bond insurance policy. Despite forbearing creditors having demonstrated their continued commitment to the RSA, and even facilitating the utility's payment of debt service owed on 1 July via a bond purchase agreement (see our Municipal Brief, Puerto Rico Credit & Market Update, 5 July 2016 for more details), we have strong doubts as to the ultimate viability of the RSA in its current form. Among other conditions, the RSA requires the new PREPA-RC SPV bonds to have an investment grade rating. We are doubtful of the ability to achieve this, but recognize that this requirement could be amended by forbearing creditors in the interest of moving forward with the planned debt restructuring following years of discussions toward this objective. The RSA also requires 100% participation by all Fuel Line and GDB Line of Credit (LOC) creditors, 100% of Ad-Hoc Group creditors and 100% of non Ad-Hoc Creditors, less USD 700mn in par allowed to remain outstanding. 9 We consider this to be another difficult hurdle. With so many different parties with varying goals, we view the implementation of this RSA as a heavy lift. To counter these challenges PREPA may attempt to use the creditor collective action provisions under PROMESA to bind all creditors to the RSA. 10 If the RSA is unsuccessful, we would expect PREPA to seek protection from creditors under PROMESA. Our recovery estimates would change accordingly under this scenario as new information becomes available. Again, please refer to Appendix II for the takeaways from our recovery analysis. Conclusions and outlook We expect the Puerto Rico Financial Oversight and Management Board to refrain from taking immediate action, choosing instead to familiarize itself with the Commonwealth's exceptionally complex financial statements. The Board also will likely prefer to await the election of a new governor in November before exercising executive authority. As we have opined in the past, Puerto Rico's financial distress is unprecedented and a comprehensive solution will be far more difficult CIO WM Research 5 October

8 to implement than in Detroit or in other instances of municipal insolvency. Among other challenges, we expect extensive litigation over the relative priority of payments for operations and debt service. While the presence of an independent Board is a positive development, we do not foresee a prompt resolution. Instead, investors should be prepared for a belated economic recovery and additional defaults on many obligations. While we were gratified to see that the Commonwealth is setting aside sales tax revenue for the payment of COFINA debt service, we are reluctant to conclude that these bonds are immune from a restructuring that reduces outstanding principal. Disagreements among creditors holding different bonds, including general obligations, may force the next gubernatorial administration and the Oversight Board to reconsider the degree to which COFINA bondholders are exempted from realized losses. We prefer the senior COFINA obligations over subordinate debt over the longer term but, as we await further word from the Oversight Board, the price of subordinate lien COFINA bonds due in 2017 should improve incrementally if required set-asides continue to be made. Meanwhile, PREPA has been attempting a comprehensive restructuring of outstanding debt for more than two years. The utility has the means to implement the necessary reforms, but progress has been exceedingly slow, and the example this has set for other distressed agencies is very discouraging. Fortunately, many of the requirements set forth in the utility's Restructuring Support Agreement have been met. And, while the need for an investment grade rating remains a significant obstacle to a restructuring, the presence of a new Board with oversight authority raises the probability of a final resolution along the lines set forth in the RSA. Uninsured bondholders who participate in the RSA should receive approximately 75 cents on the dollar on a net present value basis; insured bondholders should receive full repayment. CIO WM Research 5 October

9 Appendix I: A focus on COFINA The 1 August 2016 debt service payment was made to Puerto Rico Sales Tax Financing Corp. (COFINA) bondholders. Due to the legal structure of the COFINA funding mechanism, the funds for the 1 August 2016 debt service payment had been held by the Trustee, Bank of New York Mellon, for several months. The Commonwealth of Puerto Rico's 2017 fiscal year started on 1 July This is also the starting point for the COFINA trust to accumulate the necessary funds for repayment of obligations due in the subsequent February and August. Under the indenture, these sales tax receipts are supposed to accumulate in the trust account until the base amount (minimum requirement) for the fiscal year is reached. In the fiscal year, the base amount is USD 708.5mn. After the base amount is reached, pledged revenue then flows to the Puerto Rico general fund. 11 Based off the trailing two years of sales tax collections seen in Fig. 5, the COFINA trust typically reaches its annual requirement between December and January. Sales tax revenue for the first two months of FY17 (July and August) flowed to the COFINA trust in accordance with the COFINA indenture. 12 As of 1 September 2016, the bond trustee had received USD 241.3mn of sales tax revenue, or 34% of the total annual requirement. Based on this report, the senior lien debt service bucket has already reached its required amount for the fiscal year. Clients who hold senior lien COFINA securities can therefore expect to receive full debt service payments for 1 February 2017 and 1 August The subordinate lien will need an additional USD 467.2mn of sales tax revenue in this fiscal year before we can assert that the subordinate lien will also be paid in full for the period. We will continue to follow the Puerto Rico Treasury Department's monthly disclosure to see if these payments continue to flow to the bond trustee as required. If payments continue to flow to the COFINA trust in the coming months, we would expect for the 2017 maturity COFINA subordinate bonds Fig. 5: Monthly sales tax receipts In USD 000s Fiscal year 2017 (preliminary) Annual totals July August September October November December January February March April May June Total 209, , ,379 COFINA 119, , ,347 General Fund 89,791 91, ,032 Fund of Municipal Administration (FAM) - - Cinema Fund - - Fiscal year 2016 July August September October November December January February March April May June Total 154, , , , , , , , , , , ,313 2,376,840 COFINA 142, , , , , ,099 7, ,259 General Fund 11,643 82,130 76,286 77,545 82,184 92, , , , , , ,842 1,559,627 Fund of Municipal Administration (FAM) ,218 9,338 9,487 9,894 9,576 10, ,714 Cinema Fund , ,240 Fiscal year 2015 July August September October November December January February March April May June Total sales tax recipts 113, , , , , , , , , , , ,127 1,417,007 COFINA 113, , , , , , ,480 General Fund , ,781 98, , , , ,253 Fund of Municipal Administration (FAM) ,507 48,812 9,334 8,989 10,003 9,878 10, ,034 Cinema Fund , ,240 Source: Puerto Rico Department of Treasury, UBS, as of 15 September CIO WM Research 5 October

10 to see their prices rise toward par as full debt repayment becomes more possible. 13 The bonds traded at an average price of USD as of 29 September For clients who own the 2017 maturity COFINA subordinate bonds, we recommend holding the securities at this time. If the COFINA Trust continues to receive monthly sales tax revenue, we would expect these securities to see their prices rise toward par in the coming weeks/months. This has the potential to allow bondholders to sell their securities at higher prices than where they are currently priced (see Fig. 6). We are reluctant to advise private clients that do not already hold COFINA obligations to buy them now in the open market. While existing holders can take some comfort in the current set-asides for the payment of FY17 debt service, the inherent competition among creditors introduces risk that is difficult to quantify. If the Commonwealth suspends its set-asides and the risk of default increases abruptly, the resulting price reduction would be substantial. In that case, recent buyers may be obliged to accept a greater loss since distressed pricing typically reverts back toward the longest dated maturity's price, which is currently approximately USD 45. Fig. 6: Historical and possible future pricing on subordinate COFINA bonds due in 2017 Par in USD If COFINA bond trustee continues to recieve daily sales tax revenues, pricing will begin to rise toward par USD Jun-16 Jul-16 Aug-16 Sep-16 Oct-16 Nov-16 Dec-16 Jan-17 Note: Solid line indicates pricing on subordinate COFINA bonds issued on 18 June 2009 with a 4.25% coupon maturing on 1 August Historical pricing through 30 September Dotted line indicates price changes in our theoretical scenario in which the bond trustee would have received funds sufficient to meet final interest and principal payment by January Source: Bloomberg, UBS, as of 30 September CIO WM Research 5 October

11 Appendix II: A focus on PREPA The restructuring of Puerto Rico Electric Power Authority (PREPA) debt continues to move forward, albeit at a snail's pace. The first version of the Restructuring Support Agreement (RSA) was announced in an EMMA filing on 22 July 2015, the product of nearly a year of earlier negotiations between the power utility and its largest creditors after entering into a bond forbearance agreement in August Since July, the RSA has gone through several changes, with the most recent version, dated 30 June 2016, evaluated in this report. A theoretical recovery analysis for the RSA is set forth below. Our analysis is fully contingent on the RSA closing successfully, and applies exclusively to uninsured bondholders. We continue to believe PREPA bondholders holding bonds that are insured by National Public Finance Guarantee and Assured Guaranty will be repaid in full on the basis of the bond insurance policy. Despite forbearing creditors having demonstrated their continued commitment to the RSA, and even facilitating the utility's payment of debt service owed on 1 July via a bond purchase agreement (see our Municipal Brief, Puerto Rico Credit & Market Update, 5 July 2016 for more details), we have strong doubts as to the ultimate viability of the RSA agreement in its current form. Among other conditions, the RSA requires the new PREPA Revitalization Corp. Special Purpose Vehicle (PREPA-RC SPV) bonds to have an investment grade rating. We are doubtful of the ability to achieve this, but recognize that this requirement could be amended by forbearing creditors in the interest of moving forward with the planned debt restructuring following years of discussions toward this objective. Fig. 7: Options under current PREPA restructuring proposal Option A Option B Current fixed rate bonds Bondholders benefit from the creation of the new PREPA-RC SPV entity Restructured bonds coupon ranges between %, with final coupon contingent on PREPA-RC SPV's rating Accept 85% exchange ratio (15% principal haircut) The bonds will have a ten year call, callable at par thereafter Sinking fund starting in 2022 Final maturity of 2043 Capital appreciation bonds (CABs) Bondholders benefit from the creation of the new PREPA-RC SPV entity New bonds coupon ranges between %, with final coupon contingent on PREPA-RC SPV's rating Accept 85% exchange ratio (15% principal haircut) The bonds will have a ten year call, callable at par thereafter No principal or interest for five years Final maturity of 2043 Option C Uninsured bonds are tendered for a yet undisclosed price Option D No more than USD 700mn of uninsured legacy PREPA revenue bonds are permitted to remain outstanding These legacy PREPA bondholders receive their revenues under the pre-existing flow-of-funds under PREPA's indenture Source: PREPA, UBS, as of 4 October The RSA also requires 100% participation by all Fuel Line and GDB Line of Credit (LOC) creditors, 100% of Ad-Hoc Group creditors and 100% of non Ad-Hoc Creditors, less USD 700mn in par allowed to remain outstanding. We consider this to be another difficult hurdle. With so many different parties with varying goals, we view the implementation of this RSA as a heavy lift. To counter these challenges, PREPA may attempt to use the creditor collection action provision under PROMESA to bind all creditors to the RSA. If the RSA is unsuccessful, we would expect PREPA to seek protection from creditors under PROMESA. Our recovery estimates would change accordingly under this scenario as new information becomes available. Options under current restructuring proposal We consider the possible recovery outcomes under the RSA, as it is currently set forth, below. In broad terms, it calls for uninsured bondholders to select 'Options A D'. Option A: New current interest bonds Option B: New convertible capital appreciation bonds Option C: Cash tender CIO WM Research 5 October

12 Option D: Maintain existing bonds (do nothing) The selection of Options A or B requires a principal haircut of 15% (85% exchange ratio) in exchange for the proposed PREPA-RC SPV bonds. See Fig. 7 for more detail. Recovery value analysis conclusions Option A: Approximately 74 cents per dollar Option B: Approximately 78 cents per dollar Option C: N/A Option D: Approximately cents per dollar We describe how we arrived at these estimates, by option, below. 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 the true recovery value is a client's sale price, and also that these are just estimates, actual recovery could vary. Option A If an uninsured bondholder selects 'Option A,' they would exchange their existing bond for a new PREPA-RC SPV bond that retains 85% of the principal and has an automatic 2043 maturity with a mandatory sinking fund starting in By selecting 'Option A,' we assume a 4.75% coupon rate on the restructured bonds, and that the new PREPA-RC SPV entity will receive a BBB-/Baa3 rating from one or all of the rating agencies. In this analysis, we select a 6.06% discount rate on the securities. This rate was based on the current BAA MMD curve in 30 yrs bps, which presently equals 6.06% (3.06% + 300bps = 6.06%). It is important to note that discount rates change daily, and thus the theoretical recovery value changes daily. See Fig. 8 (following page) for an example of what the cash-flows are for a current PREPA bond and the new PREPA-RC SPV bond when using the assumptions discussed above for 'Option A.' The theoretical recovery value is USD (USD 74) cents on the dollar. Option B If an uninsured bondholder were to select 'Option B,' they would exchange their PREPA bond for a new PREPA-RC SPV bond that retains 85% of the principal value and has an automatic 2043 maturity with no coupon payments for the first five years. By selecting 'Option B,' we assume a 5.50% coupon rate on the restructured bonds, and that the new PREPA-RC SPV entity receives a BBB-/Baa3 rating from one or all of the three rating agencies. In this analysis we select a 6.06% discount rate on the securities. This rate was based on the current BAA MMD curve in 30 years bps, which presently equals 6.06% ( bps = 6.06%). It is CIO WM Research 5 October

13 important to note that discount rates change daily, and thus the theoretical recovery value changes daily. See Fig. 8 for an example of what the cash-flows are for a current PREPA bond and the new PREPA-RC SPV bond when using the assumptions discussed above for 'Option B.' Presently, the theoretical recovery value is USD (USD 78) cents on the dollar. Bondholders are rewarded with a higher recover value under 'Option B' than 'Option A' because they forgo coupon payments for the first five years, along with a higher coupon payment overall. Fig. 8: PREPA RSA debt recovery cash-flow analysis Maturity Exchange ratio Coupon Discount rate Estimated recovery rate Option A 1 July % 4.75% 6.06% 73.73% Option B 1 July % 5.50% 6.06% 77.79% Bond cash-flows before debt restructuring Option A: New bond cash-flows Option B: New bond cash-flows Date Principal Interest Principal Interest Principal Interest 9/30/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ Sinking 7/1/ Fund /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ /1/ No principal or interest Source: PREPA, UBS, as of 4 October CIO WM Research 5 October

14 Option C If PREPA tenders for bonds, we expect the pricing to commence below the current prevailing market price for PREPA debt. The likely target of these tender offers will be non-traditional investors who purchased bonds at deep discounts. The market is currently unable to digest large quantities of PREPA debt, since there are limited new buyers of these securities. PREPA will likely attempt to capitalize on this and seek to tender debt at discounts to the prevailing market price. Option D As a condition to PREPA closing the RSA successfully, no more than USD 700mn par of the uninsured bondholders who are not party to the Ad Hoc Group may keep their pre-existing PREPA bonds. These securities would mature on time and in full if PREPA does not become a serial defaulter. 'Option D' stipulates that bondholders would continue to receive payment under the existing terms of PREPA's indenture. For example, if a client owns a PREPA bond with a 5% coupon and 2024 maturity, that client would expect to receive 5% through 1 July 2024, with principal repayment occurring at maturity. If PREPA attempts to restructure its debt again while this bond remains outstanding, these bondholders would not be protected by the new PREPA-RC SPV entity. Under 'Option D,' likely recovery value is more difficult to discern. If a client owns a PREPA bond with a 2020 maturity, for example, the likelihood of PREPA attempting to restructure within three years is low, and thus this bondholder could be repaid in full. If a bondholder opts for 'Option D' and owns a 2043 maturity, however, the longer dated maturity involves significantly more risk, and we believe that overall recovery could be vastly lower if PREPA defaults again in the future. If PREPA manages to restructure all of its debt, less the USD 700mn traunch permitted under the terms of the proposal, we expect that the utility's financial condition would be significantly better than it is currently. The counter to this argument is that Puerto Rico's economy is on a declining trend, and irrespective of what PREPA does to restructure its debt, risks remain that its customer base will continue to dwindle, leading to serial defaulter status. While we believe that a cent recovery range under 'Option D' is reasonable, and accounts for the broader credit risks facing the utility, as well as the thousands of scenarios that encompass each bond maturity, we are obliged to reiterate that this is an estimate, and actual recovery under this option, as well as other scenarios, could vary. Lastly, as mentioned previously, 'Option D' could be retracted under the RSA if PREPA seeks, and successfully uses, the creditor collective action provision under PROMESA. CIO WM Research 5 October

15 End notes 1 Skeel David, "A Puerto Rican Solution for Illinois," Commentary, The Wall Street Journal, 3 August According to Mr. Skeel, "A federal bankruptcy law covering Illinois (or New York or New Jersey or California) would trump any state constitutional provisions or court decisions and permit the restructuring of unfunded pension obligations. It would also give a hopelessly overextended state breathing room to return its finances to balance. The prospect that unsustainable pension promises could be restructured would give lawmakers and public employees in every state a much greater incentive to avoid making unrealistic promises." 2 Skeel, David, "Fixing Puerto Rico's Debt Mess," Opinion, The Wall Street Journal, 5 January Moody's, "State and Local Governments US: FAQ: PROMESA Raises the Stakes in Clash Between Municipal Bonds and Public Pensions," 11 August Standard & Poor's, "Puerto Rico Sales Tax Financing Corp. Likely to Make Next Interest Payment Despite Possibility of Default," 29 September Note, pledged revenue does not include any incremental sales tax revenue resulting from a 4.5% increase in the sales tax rate (from 7% to 11.5%) that was signed into law by Governor García on 29 May The stay, under PROMESA, applies only to a "liability claim," which is defined as a: "bond, loan, letter of credit, other borrowing title, obligation of insurance, or other financial indebtedness for borrowed money, including rights, entitlements, or obligations whether such rights, entitlements, or obligations arise from contract, statute, or any other source of law related to such a bond, loan, letter of credit, other borrowing title, obligation of insurance, or other financial indebtedness in physical or dematerialized form." 7 Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA); Section 104. Powers of Oversight Board: 104(i)(3). 8 The PREPA Revitalization Act was enacted on 16 February Seven lawsuits have been filed, contesting the validity of the Revitalization Act. Affirmation of the Revitalization Act by the courts will enable the issuance of the PREPA-RC SPV bonds. 9 Fuel Line of Credit: Citibank; Bank of Nova Scotia; GDB Line of Credit: NA; Ad Hoc Group: Angelo Gordon; Blue Mountain; Franklin Advisors; Goldman Sachs; Knighthead Capital Management LLC; Marathon Asset Management LP; Oppenheimer Funds, Inc.; Solus Alternative Asset Management LP; National Public Finance Guarantee; Assured Guaranty Corp; Syncora Guarantee Inc.; MassMutual; Penteli Master Fund, LTD; Baldr Mason Fund Inc., KTRS Credit Fund, LP. 10 Section 601 of PROMESA 11 Note, pledged revenue does not include any incremental sales tax revenue resulting from a 4.5% increase in the sales tax rate (from 7% to 11.5%) that was signed into law by Governor García on 29 May 2015, which flows directly to the general fund with the exception of 1% that is dedicated to municipalities. 12 Treasury Department of Puerto Rico; Monthly Distribution of Total SUT Collections Cusips: 74529JJX4, 74529JGU3, 74529JND3 CIO WM Research 5 October

16 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 5 October

17 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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At any time, investment decisions (including whether to buy, sell or hold securities) made by UBS AG, its affiliates, subsidiaries and employees may differ from or be contrary to the opinions expressed in UBS research publications. Some investments may not be readily realizable since the market in the securities is illiquid and therefore valuing the investment and identifying the risk to which you are exposed may be difficult to quantify. UBS relies on information barriers to control the CIO WM Research 5 October