What Happens in Puerto Rico may not Necessarily Stay in Puerto Rico

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1 What Happens in may not Necessarily Stay in Eric Friedland, Head of Municipal Research October 2013 The municipal market endured a period of volatility, particularly over the summer, due to the fear of rising rates and negative headlines surrounding Detroit and. Municipal mutual funds have seen outflows for the last 33 weeks beginning in May (see Municipal Value across the curve Although the prices have rebounded slightly since early September, the municipal market still offers value. The Commonwealth of continues to generate negative press, as its bonds have been under price pressure resulting in part from recent credit downgrades from all three rating agencies. This does not surprise us, as noted in our previous comments earlier this year (see : Risk outweighs Reward bonds are widely held in municipal bond mutual funds because of their triple tax exemption. As such, a further deterioration in the credit could increase or reignite the pace of sell-off, similar to what the market experienced over summer. bond price declines have been dramatic. Bonds issued by the Commonwealth of have reported negative returns during 2013, much greater than that of the general municipal market. The S&P Municipal Bond Index is down 19% in 2013, underperforming the S&P National AMT-Free Municipal Bond Index, which is down only 3.6%. While the losses have moderated over the past several weeks, the potential for further impairment is high. The price deterioration can be attributed to both technical and credit factors, which have fueled each other to create further distress. While credit contagion is not likely, future developments in the Commonwealth could have systemic implications for the general municipal market.

2 Talking Point What Happens in may not Necessarily Stay in Bond fund redemptions and headlines have resulted in forced selling. Although the underperformance of bonds can be attributed to many issues, technical factors are proving to be prominent. Interest payments on bonds are exempt from state and local taxes in all 50 states, which have made the Commonwealth s high-yielding bonds appealing for mutual fund managers. In fact, more than 75% of municipal bond funds tracked by Morningstar own bonds. Many fund shareholders, particularly those invested in state specific funds, are not aware that their funds depended on paper to achieve the funds' return objectives. These funds are currently suffering from a prolonged trend of redemptions and are now being forced to trim their positions. Headlines in the mainstream press, such as the New York Times, Barrons and the Wall Street Journal, are causing individual investors to sell their bonds. However, recent bond trading is dominated by hedge funds and other crossover investors, all speculating on where the price floor may be. Individual retail investors face pressure as it is difficult for them to compete against these more seasoned traders. The negative feedback loop continues, with bad news leading to selling, resulting in prices moving lower. s ratings are on the brink of junk. s general obligation bonds are currently hovering one notch above investment grade (Baa3/BBB-/BBB-). A further rating downgrade of the general obligation bonds, to junk level ratings, will have significant consequences for the bonds. Forced selling would be spurred by the many mutual funds that by mandate or convention do not hold non investment grade bonds. Market access would be impaired and financing costs would increase due to the limited number of individual investors willing to purchase bonds rated at junk levels. Further, additional collateral posting requirements on outstanding swaps could be triggered by a downgrade to below investment grade. The Commonwealth has sizable debt outstanding, with many of the credits intertwined. has approximately $70 billion of debt outstanding, issued by a dozen different agencies, each with unique security structures. Bonds issued by COFINA, which are secured by sales taxes, account for the largest portion of the debt, with $16.6 billion outstanding. The general obligation bonds account for the next largest credit category, with $11.1 billion outstanding. Much of the remaining debt is accounted for by bonds issued by the Commonwealth s enterprise systems. Unlike typical revenue bonds, which are legally separate from the general obligation bonds, many of those issued by are exposed to potential claw back provisions if revenues are insufficient to support debt service on the general obligation bonds. Therefore, the credit quality of the many issuers is intertwined, which results in a massive number of rating changes whenever the rating agencies take rating actions. The COFINA bonds are the highest rated of the Commonwealth s debt, given the lack of claw back and a structure which creates adequate debt service coverage. However, even these ratings have come under pressure as the rating agencies are linking them closer to the general obligation bonds. Outstanding Bonds Issued by the Commonwealth Issuer Ratings Debt Outstanding (incl FV of CABS) General Obligation Baa3/BBB-/BBB- $11.1b Guaranteed Debt Baa3/BBB-/BBB- $5.4b Pension Obligations Baa3/BBB-/BBB- $2.8b Public Finance Corp Ba1/BBB-/NR $2.1b Infrastructure Finance Authority Baa3/BBB+/NR $3.0b COFINA-Sales Tax-Senior Lien A2/AA-/AA- $16.6b (including all COFINA) COFINA-Sales Tax-Subordinate Lien A3/A+/A+ Electric Baa3/BBB/BBB- $8.5b Aqueduct & Sewer Ba1/BB+/BBB- $3.7b Highway-Highway Revenue Baa2/BBB+/NR $5.6b (including all Highway) Highway-Trans Revenue Baa3/BBB/NR Highway- Sub Trans Ba1/BBB-/NR Government Development Bank Baa3/BBB-/NR $9.4b

3 Talking Point What Happens in may not Necessarily Stay in Securities shown are for illustrative purposes only and should not be viewed as a recommendation to buy/sell. Credit quality is the average credit quality of the securities in the portfolio as opposed to a credit rating that has been assigned to the portfolio by an NRSRO. The bond insurers have significant exposure. With approximately 24% of the Commonwealth s bonds insured, widespread defaults could result in meaningful credit deterioration of several of the bond insurers. Of concern, is the fact that the largest exposure is held by two of the three insurers that have investment grade ratings, Assured Guaranty with $5.5 billion and National with $5.3 billion. If there is a default on bonds, insurer downgrades could result from the claims that would be forced upon these insurers, which in turn would ripple to a broader part of the municipal market. The fundamental credit quality of s bonds remains weak. The Commonwealth s economy has suffered from a prolonged recession that began several years before the rest of the United States. This was due in part to the phase out of the special treatment of possession income, which had benefitted the pharmaceutical companies. Once the benefit ended in 2006, many of the companies left for lower cost alternatives like Ireland. Even as the mainland U.S. economy is slowly recovering, remains in recession. s GDP contracted by 9% in aggregate between 2005 and Ongoing population decline (1.5% population loss in 2011 alone) continues to drive down the tax base, putting more pressure and higher taxes on those who remain. Extraordinarily high energy prices, driven by the Commonwealth s reliance on oil fueled generation, has resulted in onerous business costs. s unemployment rate, which was 13.7% in July 2013, continues to be almost twice as high as the U.S. average. The cost of living is high, as the average ratio of home listing price to household income in the United States is 3.78x, but s ratio is a much higher 10.46x (as reported by JP Morgan). The Commonwealth has had a structural budget deficit for the past five years, ranging from $2.9 billion in 2009 to $1.2 billion in 2012 (which represents 13.7% of budgeted revenues). The budget deficit is expected to improve to $820 million by 2014, but that is dependent upon aggressive revenue projections (which are based on economic growth projections of 1.2%.) and the implementation of debt refinancings and other one-time fixes. Further, more than $1 billion of the administration s spending plan relies on new tax measures (mostly corporate taxes). The Commonwealth s ability to fully collect taxes will need to be improved upon for their goal to be achieved. With rating outlook negative, we will be closely observing trigger factors. With the general obligation bond ratings on negative outlook by all three rating agencies, we believe that a downgrade to below investment grade is likely in The rating agencies have been clear in their statements; the Commonwealth will need to demonstrate this year that they can create a structurally balanced budget, incorporating rational and achievable assumptions. The market will be watching closely for any signs that will trigger a rating change. We will be keeping our eye on several factors. Of critical importance is how well the Commonwealth is able to meet their revenue estimates. First quarter 2013 results have been reported, and although revenues are higher by 4% on a year to year comparison, they are short of projections. At the same time, expenses will need to be controlled, in particular healthcare and education, which account for largest portions of the budget. The rating agencies have been highly critical of the Commonwealth s very low 9% funding level for the pension funds. Although pension reform has been initiated, the expectation is that more progress will need to be made. Maintaining market access to fund capital programs and maintain liquidity will be required. Signs that the Commonwealth is unable to obtain funding, either in public or private markets, will indicate severe credit stress. Finally, the market will be following the progress of an investigation led by the the Massachusetts Secretary of the Commonwealth regarding the suitability of bonds being placed into single state funds. This type of investigation could spread to other states and could result in wider spreads and more limited market access. Reform is being implemented, but the hole is deep. The government has not been idle and has been active in trying to get its house in order. Significant pension reform was passed this year and new revenues have been raised, such as a new business tax, which is a temporary excise tax on certain purchases by offshore companies. In addition, 60% rate increases were implemented for the Commonwealth s water and sewer enterprise. Further, the main airport has been privatized and a new energy policy is being developed in an effort to lower electricity costs. However, s credit deterioration is deep and it will take several years and meaningful programmatic change for the recovery to commence.

4 Talking Point What Happens in may not Necessarily Stay in A federal bailout is unlikely. Similar to U.S. states, in not legally able to file for bankruptcy. However, the fear remains that at some point, they may not have the means to provide for payments on their bonds and that they will default. The question of federal assistance has been raised, and there have been reports of discussions between Commonwealth and Federal officials in this regard. Although an outright bailout is unlikely, other possibilities have been suggested. A financial control board could be created, similar to the one put in place when New York City was in distress. However, congressional legislation would be required at a time when very little is being legislated in Washington DC. Other than that, it has been suggested that the federal government could directly fund and control operations of certain programs, such as healthcare and education, which account for approximately 60% of the budget. Finally, the federal government could guarantee subsequent bond issues. All of these alternatives would be helpful, but implementing any one of them will be challenging. There may be investment opportunities outside of bonds. It should be clear from this commentary that we believe that s fundamental credit quality is weak and that technical factors could result in systemic pressure for the broader municipal market. We do not hold any bonds issued by the Commonwealth and although prices are very cheap, our concern for further credit deterioration precludes us from making any purchases. Fortunately, s credit problems are idiosyncratic and the majority of U.S. municipal issuers are in good health. Therefore, we would take advantage of any broad market declines by investing in strong issuers that offer attractive risk adjusted returns.

5 Talking Point What Happens in may not Necessarily Stay in Important Information: The views and opinions contained herein are those of the Eric Friedland, Head of Municipal Research, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This newsletter is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument mentioned in this commentary. The material is not intended to provide, and should not be relied on for accounting, legal or tax advice, or investment recommendations. Information herein has been obtained from sources we believe to be reliable but Schroder Investment Management North America Inc. (SIMNA) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of facts obtained from third parties. Reliance should not be placed on the views and information in the document when taking individual investment and / or strategic decisions. Past performance is no guarantee of future results. Sectors/regions/companies mentioned are for illustrative purposes only and should not be viewed as a recommendation to buy/sell. The information and opinions contained in this document have been obtained from sources we consider to be reliable. No responsibility can be accepted for errors of fact obtained from third parties. Schroders has expressed its own views and opinions in this document and these may change. The opinions stated in this document include some forecasted views. We believe that we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee that any forecasts or opinions will be realized. Schroder Investment Management North America Inc. ( SIMNA Inc. ) is an investment advisor registered with the U.S. SEC. It provides asset management products and services to clients in the U.S. and Canada including Schroder Capital Funds (Delaware), Schroder Series Trust and Schroder Global Series Trust, investment companies registered with the SEC (the Schroder Funds.) Shares of the Schroder Funds are distributed by Schroder Fund Advisors LLC, a member of the FINRA. SIMNA Inc. and Schroder Fund Advisors LLC. are indirect, wholly-owned subsidiaries of Schroders plc, a UK public company with shares listed on the London Stock Exchange. Further information about Schroders can be found at Schroder Investment Management North America Inc. is an indirect wholly owned subsidiary of Schroders plc and is a SEC registered investment adviser and registered in Canada in the capacity of Portfolio Manager with the Securities Commission in Alberta, British Columbia, Manitoba, Nova Scotia, Ontario, Quebec, and Saskatchewan providing asset management products and services to clients in Canada. This document does not purport to provide investment advice and the information contained in this newsletter is for informational purposes and not to engage in a trading activities. It does not purport to describe the business or affairs of any issuer and is not being provided for delivery to or review by any prospective purchaser so as to assist the prospective purchaser to make an investment decision in respect of securities being sold in a distribution. Further information on FINRA can be found at Further information on SIPC can be found at Schroder Fund Advisors LLC, Member FINRA, SIPC 875 Third Avenue, New York, NY