Puerto Rico Default

Puerto Rico’s Public Finance Corporation (PFC) missed most of a US $58 million bond payment due August 1st, the first default by the commonwealth in what may become one of the largest restructurings ever in the municipal market. Puerto Rico has about $5 billion in interest and principal due over the next 12 months. Many of the island’s agencies that have issued bonds are expected to restructure in the coming months. Investors should expect increased volatility and should prepare for eventual haircuts to their original investments as restructuring talks develop. Puerto Rico’s crisis has escalated after years of government overspending, a declining population (7% over the last 10 years), and persistently weak economic performance. The commonwealth’s economy has contracted every year but one since 2006 and is expected to decline by 1.2% this year.

The PFC, a subsidiary of the Government Development Bank (GDB), currently has approximately US $1 billion of debt. PFC bonds have weaker protections than many other Puerto Rico bonds given payment relies on legislative appropriation. Conversely, other bonds have a dedicated revenue stream associated with them or, like the General Obligation bonds (GO bonds), are protected by Puerto Rico’s constitution and have a claim on government revenue.

Standard & Poor’s (S&P) said the missed payment foreshadows other possible defaults, and added it would impede Puerto Rico’s ability to obtain financing for cash flow needs. S&P lowered its rating on US $1 billion of PFC debt following the default to ‘D’ from ‘CC’. Fitch Ratings rates the commonwealth’s GO and related debt ‘CC’; Rating Watch Negative, which indicates Fitch’s belief that default of some kind appears probable. According to Fitch, as Puerto Rico’s restructuring plans become clearer, a downgrade to ‘C’ would be triggered on a security-specific basis when default appears inevitable.

In August, Puerto Rico faces a Sales Tax Financing Corp. (Cofina by its Spanish acronym) payment of approx. US $330 million, as well as payments of US $91.5 million on Municipal Finance Authority (MFA) debt, US $1.5 million on GO bonds and US $13.9 million for the Government Employees Retirement System. Puerto Rico’s Chief of Staff, Víctor Suárez, said all of the above should be completed without any setbacks. Despite missing the PFC payment, Puerto Rico’s government confirmed it made a separate US $169.6 million payment on outstanding GDB notes that were due on the same day.

U.S. Treasury Secretary Jacob Lew recently mentioned that the Puerto Rico crisis would have to be resolved by local officials in cooperation with bondholders given Washington would not deliver a federal bailout. Unlike U.S. states, Puerto Rico has no access to bankruptcy courts for its government entities, further complicating potential restructures. As advocated by Secretary Lew, U.S. Congress may need to pass a bankruptcy bill allowing some Puerto Rico agencies to file for Chapter 9 bankruptcy protection to ensure an orderly restructure. The Garcia Padilla administration has urged Congress to work with its officials on passing such bills.

As the island’s financial situation worsens, commonwealth officials are scrambling to prepare a debt-restructuring plan, scheduled for completion by September 1st, and a five-year fiscal plan to improve the economy and balance the budget. Facing approximately US $5 billion in total payments due over the next 12 months, the government will likely need to address substantial, structural changes, as well as continue to seek liquidity measures in the near term.

Authored by: Roberto Erana & Alex Trueba