Municipal Fixed Income

C OMM E N T A R Y

April     2 0 13

Robert Collins

Head of Municipal Fixed Income rfcollins@wilmingtontrust.com 302.651.8953

MUNICIPAL  STRATEGY

Puerto Rico on the precipice

by   Karleen   Strayer Senior Municipal Credit Analyst and

Stephen Winterstein

Managing Director & Chief Strategist

K E Y  P O I N T S:

• Puerto Rico’s ability to pay its bills is not strong, as reflected by the major bond ratings agencies all having assigned the lowest of investment-grade ratings to the island’s general obligations (GOs). Some non-GOs are already assigned speculative grades.

• Puerto Rico accounts for a small fraction of the U.S. municipal bond market, but it is held in many state-specific mutual funds.

• Recently adopted pension reforms are encouraging.

• We believe Puerto Rico’s GOs nonetheless are at high risk of a downgrade into the speculative-grade universe, and we would not expect a Washington bailout.

Puerto Rico’s economic and fiscal challenges led us to divest all direct holdings in our centrally managed accounts more than a year ago, and events since then have heightened uncertainty over the prospects for Puerto Rico bonds. The three major rating agencies now all describe the general obligations of Puerto Rico as marginally investment-grade, with a negative outlook, so a slip into speculative-grade territory may be a hairbreadth away.

The ability of Puerto Rico’s new administration to close large structural deficits while addressing severe pension underfunding will determine whether the commonwealth keeps its investment-grade status. Although as a commonwealth of the United States, Puerto Rico has strong political and economic ties to the federal government, what this relationship means financially is much debated.

Puerto Rico represents just 3.3% of the U.S. municipal bond market, according to the S&P Municipal Bond Index. Many observers are quite concerned about the island’s financial health, despite its modest role in the market, because Puerto Rico is widely held in “state-specific” mutual funds. It is widely held in such funds because municipal bond interest derived from tax- exempt issuers in the five U.S. territories is exempt from federal, state, and local taxes, regardless of the state where the investor resides.

Investors’ reaction to recent developments

The commonwealth’s economic and financial woes and the resultant ratings agencies’ downgrades caused Puerto Rico bonds to underperform other state and territorial issues

in 2012. The Puerto Rico index returned 3.08% versus 7.42% for the S&P Municipal Bond Index. Puerto Rico’s performance was the worst of the 50 states, the District of Columbia, and the three territories tracked by the index.

Puerto Rico was the only S&P “state index” to generate a negative price return for the year. The sources of total returns for a bond portfolio or an index include yield and price change. While the Puerto Rico index generated a 3.92% yield return for 2012, largely reflecting investors’ demand for being compensated for the commonwealth’s higher credit risk, the price return was –0.84%.

The theme remained the same during the first three months of 2013, though the outcome was slightly different. The Puerto Rico index began the year with the highest yield — again, reflecting recent credit and event risks — but the commonwealth’s quarterly total return was 0.33%, seventh from the bottom. The state’s index had the largest yield return at 0.97% but the worst price return, –0.63%.

Trials and tribulations

Now we turn from the performance of Puerto Rico’s debt to the specific tribulations it faces. Challenges of the commonwealth are numerous, but four key areas stand out: persistent operating deficits, a severely underfunded pension system, a weak economy, and unsustainable debt levels.

Operating deficits

Puerto Rico’s latest estimates for its fiscal 2013 budget gap showed weakening performance, with a budget gap double the original estimate. A structural operating deficit of

$2.16 billion on a $7.84 billion revenue base resulted primarily from weaker than expected revenues. Revenues were $910 million under budget, with the largest variance in the area of corporate income taxes. Individual income taxes and sales and use taxes also came in under budget. With such a large deficit, the potential for a balanced budget in the near to intermediate term appears remote. Governor García Padilla places blame for the revenue variance on the previous administration, but his team was swift in recommending remedies. Favorably for investors, the governor voiced strong support for revenue-raising measures, such as an increase and extension to the temporary corporate excise tax under Act 154, as well as anti-tax evasion and other revenue-raising measures.

Severely underfunded employee pension system

To portray Puerto Rico’s pension system as deeply troubled severely understates the issue. It is in crisis.

A report by the Puerto Rico Government Development Bank (GDB), the commonwealth’s financial advisor, estimates the actuarial deficit at over $35 billion, or more than half of the island’s gross state product. Remaining assets of the commonwealth’s Employees Retirement System are just $1.2 billion. Prior to the reform measures described below, this amounted to just 6 cents for every dollar owed —with total asset depletion expected by 2014, according to the report. At that point, benefits would be paid from the proceeds of $3 billion of pension obligation bonds. Repayment for the pension bonds, however, comes from employer contributions that the

pension system receives so, once bond proceeds were spent, there would not be sufficient contributions to make

both pension and bondholder payments. According to  the Treasury Secretary, the pension system pays out $1.55 billion annually but receives annual income of just

$750 million.

Given the urgency of the problem and the high risk of further rating agency actions, Governor García Padilla recently signed into law a reform of Puerto Rico’s pension system. Elements of the reform include replacement of the continue employee’s pension plan with a new defined contribution hybrid plan at the start of fiscal 2014, as well as an increase in the retirement age for some employees and higher employee contributions. Without reform, the government would have used 25% of its general fund revenues by 2020 just to fund its annual pension payments, according to

the GDB. Although updated comparative pension figures are not yet available, the just-approved measures are encouraging.

Narrow economy

Unemployment remains stubbornly high in Puerto Rico at a seasonally adjusted rate of 14% in December, up 0.5% since May. According to the Bureau of Labor Statistics,

seasonally adjusted unemployment in Puerto Rico peaked in May of 2010 at 16.6%, compared to 10.8% two years earlier. Even prior to the recession, which began in 2006 for the commonwealth, unemployment historically ran at rates higher than 10%.

Unsustainable debt levels

Puerto Rico’s debt levels are extremely high, having ballooned since 2007 as budgetary gaps were filled through debt issuance and restructurings. According to Moody’s, Puerto Rico’s tax-supported debt is more than ten times that of the 50-state median. Net per capita, tax-supported debt is over $14,000 in Puerto Rico, compared to a 50-state median per capita level of $1,117. With debt at such high levels, the government is looking toward public-private partnerships as a source of liquidity. Recently, the governor authorized the privatization of the Luis Munoz Marin Airport, which is expected to provide the Ports Authority with an immediate

$615 million payment, much of which will be used to pay down loans and loan guarantees from the GDB. Other privatization programs are in process or under consideration.

Major government-related debt issuers and their current ratings from the major agencies are shown in Figure 1 (page 4). Given the linkage with the commonwealth, much of this debt has been downgraded. Further volatility is likely. Note that the commonwealth’s appropriation debt was not downgraded below investment grade by S&P, although typically this type of debt is rated at least one notch lower than general obligation debt. Moody’s, on the other hand, maintained the more traditional rating notching — assigning the debt a speculative grade.

Our outlook

Despite recent pension reform measures, we believe Puerto Rico remains on the cusp of a rating agency downgrade due to its sizable structural deficits. Without substantive fiscal improvements, one or more of the major ratings agencies will likely strip their investment-grade ratings from the general obligations of Puerto Rico, declaring them speculative in nature. If that happens, the ratings of many of the island’s non-GO bonds, such as a majority of those outlined in Figure 1, are likely to be downgraded as well. We do not think it is a foregone conclusion that Washington will provide the common- wealth meaningful financial help. Instead, Puerto Rico’s leaders may well be pressed to come up with their own path to financial stability.

Appendix A

Commonwealth of Puerto Rico

General obligation bonds are supported by a pledge of the good faith, credit, and taxing power of the commonwealth. Major sources of tax revenues are personal and business income taxes, sales and use taxes, excise taxes, property taxes, and federal excise taxes on liquor exports. Federal grants are also a key source of revenue.

Puerto Rico Public Finance Corporation

This is a subsidiary corporation of the Government Development Bank (GDB) that purchases debt of agencies and instrumentalities of the commonwealth. Bonds are payable from central government appropriations and a portion of the sales and use tax.

Government Development Bank for Puerto Rico

The GDB serves as fiscal agent and financial advisor to the commonwealth, its agencies, municipalities, and public corporations. The GDB is a depositary of commonwealth funds and is a lender to the public and private sectors. Bonds are payable from GDB revenues and other sources. Certain issues also benefit from commonwealth guarantees and/or letters of credit, or other collateral. As of its last fiscal year end (6/30/2012), the GDB had a large risk concentration to the Puerto Rico Highways and Transportation Authority. Its credit rating is linked to that of the commonwealth.

Public Ratings of Select Debt Programs as of 3/28/2013

Moody’s                      S&P                       Fitch

Commonwealth of Puerto Rico                                                                                      Baa3                                    BBB–                                                                                                                                BBB– Puerto Rico Public Finance Corporation (Commonwealth Appropriation)                                                                                      Ba1                                      BBB–

Government Development Bank for Puerto Rico (GDB)                                                    Baa3                                    BBB–

Employees Retirement System  (ERS)                                                                           Baa3                                    BBB–                                                                                                                                BBB– Puerto Rico Aqueduct and Sewer Authority (PRASA)

Commonwealth Guaranteed Bonds                                                                           Baa3                                    BBB–                             BBB–

Revenue Bonds                                                                                                      Ba1                                      BB+                                                                                                                                BBB Puerto Rico Convention Center District Authority                                                                                                                                Baa3                                    BBB+                                                                                                                                NR

Puerto Rico Electric Power Authority                                                                              Baa2                                    BBB+                                                                                                                                BBB+ Puerto Rico Highways & Transportation Authority (PRHTA)

GARVEES                                                                                                            A2                                        A+

1968 Resolution – Hwy Rev Bonds                                                                          Baa2                                    BBB+

1968 Resolution – Transportation Rev Bonds                                                             Baa3                                    BBB

Junior Transportation Revenue Bonds                                                                       Ba1                                                                                                                                BBB– Puerto Rico Infrastructure Financing Authority (PRIFA)

Speculative grades are highlighted. All other rated issues carry investment-grade ratings.

Sources: Puerto Rico Government Development Bank (Fitch ratings); Moody’s Investors Service; S&P

Employees Retirement System of the Government of the Commonwealth of Puerto Rico and its Instrumentalities (ERS)

Bonds are secured by a pledge of future employer contributions. Government employers are required to make contributions equal to at least 9.275% of their covered payrolls.

Puerto Rico Aqueduct and Sewer Authority

Bonds are payable from net revenues derived from water and wastewater services. Over 97% of Puerto Rico’s population is served by the water system and 55% by the wastewater system. Funds to upgrade and expand the system are partially funded through commonwealth appropriations.

Puerto Rico Convention Center District Authority

Bonds are payable from hotel occupancy tax revenues, which are subject to clawback if needed for commonwealth general obligation debts and other guaranteed debt. They do not constitute public debt of the government of Puerto Rico.

Puerto Rico Electric Power Authority

Bonds are payable from charges for electric services after payment of expenses. The authority’s electric generating and distribution facilities supply 99% of power consumed on the Island

Puerto  Rico  Highways  &  Transportation  Authority  (PRHTA) Highway bonds are payable from gasoline and other fuel taxes, highway tolls and certain license fees. Pledged taxes are subject to a clawback for debt service on the commonwealth’s general obligations and guaranteed debt if other revenues are insufficient. Transportation bonds are payable  out of excess revenues proceeds after payment of highway revenue bonds plus proceeds from an excess tax on certain petroleum products up to $120 million per year plus certain toll revenues.

Puerto Rico Infrastructure Financing Authority, A GDB Affiliate

Bonds are secured by a portion of federal excise taxes, presently imposed solely on Puerto Rican rum, received by the commonwealth. These taxes are subject to a clawback if necessary to pay debt service on general obligation and guaranteed debt.

Puerto Rico Public Buildings Authority