May 9, 2017— Last week, Puerto Rico’s Oversight Board (put in place by the enactment of “PROMESA,” the Puerto Rico Oversight, Management and Economic Stability Act) filed for Title III, which acts like a bankruptcy filing, for the island’s general obligation (GO) and GO-guaranteed debt. Shortly after, the agency that sold billions in Puerto Rico-backed sales tax debt (“COFINA”), also filed. While the island has generated negative headlines for several years triggered by its financial and economic woes, this “new” news is important as it represents a new chapter, literally, in the unfolding crisis. Below is a high- level perspective on the filing itself, and what it may mean for the island’s financial obligations and a perspective on the impact this event may have on the overall municipal marketplace.

Puerto Rico debt

These filings and the eventual debt restructuring will be the largest in the history of the municipal bond market, dwarfing Detroit’s filing in July of 2013. The filings represents a failure on the part of the island’s leaders and its numerous and highly diverse creditor pool to come to a negotiated debt restructuring. And, as noted above, it marks a new chapter away from the stagnation of the last several years. However, we have moved into unchartered territory and the outcome of this restructuring is highly uncertain. Our expectation is that this process will play out over years rather than months, and will be extremely litigious—at times, even chaotic, as many competing legal questions will have to be resolved. In the end, we see it as extremely costly both financially and socially without any clear winners.

We see bondholders experiencing losses much greater than what conventional wisdom held was possible as few as six months ago. At the same time, we are uncertain as to whether GO or COFINA bondholders will suffer equally, or if one debt type may fare better. We remain skeptical that any debt restructuring alone will be successful in placing Puerto Rico on the path of economic growth and prosperity over the long term.     

Potential impact on overall municipal market

While the general market impact thus far has been minimal, there is a remote “contagion” risk that we will continually monitor. There are two primary ways a contagion could impact the general market.

First, states do not have the ability to file for Chapter Nine under the U.S. Bankruptcy Code. Perversely, this has been seen as a level of GO bondholder protection, as it limits the court’s ability to mete out a state’s liquid assets among various creditors. For example, at the municipality level, Detroit taught us that in Chapter Nine, not all secured creditors are equal—pensioners received more favorable treatment than did limited and unlimited GO bondholders. Should a state like Illinois continue down its current path of fiscal irresponsibility and political paralysis, what prevents Congress from interceding on behalf of the state, just as it did in Puerto Rico? We view this risk as remote as it requires both a state like Illinois to continue down this nonfunctional path and the federal government to step in.

Second, contagion may slowly inch into the mindset of institutional municipal debt buyers. As the Puerto Rico Title III filing unfolds and we begin to see how the guarantee provided to GO bondholders stands up against other creditors (such as pensioners and other non-direct debtholders), we can gauge the value of a contract in municipal governance; that is to say, will a promise to pay, backed by a first call on available revenues, hold up in court? For example, the filing by COFINA complicates the issue. The dedicated sales tax is carved out to be dedicated to the bondholders. COFINA bondholders argue that those revenues are carved out prior to being available to the Island Commonwealth, and hence, not available for GO bondholders. As expected, GO bondholders argue the opposite, i.e., that those revenues, along with other tax collections, are first available for their obligations.

The primary takeaway from this risk of contagion is this: As a municipal obligor falls further and further down the credit spectrum, the more these risks of bankruptcy may impede upon the contractual protections provided to bondholders. 

Core narrative 

These complicated issues, and how they are ultimately resolved in Puerto Rico, could have implications for the overall municipal market. A rigorous credit approach, incorporating both credit selection and surveillance oversight to management of municipal bond portfolios, such as the one employed by Wilmington’s Municipal Fixed Income team, may help investors minimize the impact that risk of contagion could have on one’s portfolio.

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