Haris Ashley
Puerto Rico's bonds have been rated below investment grade since 2014, indicating a high level of distress or default. Despite this, the risk premium for Puerto Rican bonds remained surprisingly low, leading to speculation that investors believed the debt was implicitly insured by the US government. In 2015, Puerto Rico began to default on some of its bond commitments, and in 2017, bankruptcy was declared. This triggered a historic restructuring of approximately $73 billion of outstanding bond debt, with the largest insurer, Assured Guaranty, taking over the Puerto Rico Highway Transportation bonds. The question of whether Puerto Rico municipal bonds are insured is a complex one, with some investors speculating that the US government provides implicit insurance, while others rely on private insurance companies to insure their bond investments.
| Characteristics | Values |
|---|---|
| Are Puerto Rico municipal bonds insured? | Yes, by companies like Assured Guaranty, AGM, and Assured Guarantee. |
| Are they a good investment? | No, they are rated below investment-grade and are considered high-risk. |
| What is the risk? | Puerto Rico has defaulted on bond commitments and declared bankruptcy. |
| What happens if they default? | The insurance company covers any payment shortfalls. |
| What is the role of the US government? | The US government has not bailed out Puerto Rico, but there is an expectation that it might. |
| What is PROMESA? | A US law that allows for the restructuring of Puerto Rico's debt. |
| What is the Oversight Board? | A body that negotiates plans to lower Puerto Rico's debt and represents Puerto Rico in debt restructuring. |
| What is the latest update? | In January 2022, a US court confirmed a plan to restructure $33 billion in liabilities and $55 billion in pension liabilities. |
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What You'll Learn
Puerto Rico's fiscal crisis
The Puerto Rico Oversight, Management, and Economic Stability Act of 2016 (PROMESA) was enacted to address the crisis. PROMESA enables Puerto Rico to restructure its debt and work towards fiscal responsibility. The Financial Oversight and Management Board for Puerto Rico, created by PROMESA, plays a crucial role in negotiating plans to lower Puerto Rico's debt to sustainable levels. The Board's plans are subject to confirmation by a federal court, and once approved, become binding on all creditor groups.
The Plan of Adjustment, established under PROMESA, aims to prevent a recurrence of the practices that led to the accumulation of unsustainable debt. It outlines specific conditions for taking on new debt and refinancing existing debt. Additionally, it prioritises maintaining and improving Puerto Rico's roads and public transportation system.
In January 2022, the U.S. District Court for the District of Puerto Rico confirmed a significant restructuring plan, reducing the Commonwealth's total debt service payments by more than 60%. This marked a crucial step towards ending Puerto Rico's bankruptcy and addressing the fiscal crisis.
While the period of financial crisis in Puerto Rico is coming to an end, the island's future economic sustainability relies on its commitment to fiscal responsibility and avoiding past mistakes.
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US municipal debt restructuring
Chapter 9 Bankruptcy Proceedings:
Municipalities can pursue debt restructuring through Chapter 9 bankruptcy, which provides a legal framework for reorganizing finances. This option is typically considered when a municipality is facing significant financial difficulties and is unable to meet its debt obligations. During this process, the municipality works with creditors to negotiate and adjust debt repayment terms, potentially reducing borrowing costs and interest rates.
Oversight and Negotiations:
In the case of Puerto Rico's debt crisis, an independent Financial Oversight and Management Board was established under PROMESA (the Puerto Rico Oversight, Management, and Economic Stability Act). This board played a crucial role in investigating the factors contributing to the fiscal crisis and negotiating debt restructuring plans. The board represented Puerto Rico in negotiations with creditors, aiming for consensual agreements that served the interests of all stakeholders.
Bond Issuance and Refinancing:
Municipalities often utilise bond issuance as a tool for debt restructuring. This involves issuing new bonds to repay existing debts, taking advantage of lower interest rates or more favourable terms. Strategies such as advance refunding and "forward delivery" bonds allow for refinancing of existing bonds in advance of their maturity dates, potentially generating savings. The municipal bond market offers various strategies for managing debt, including private activity bonds and tax-exempt revenue bonds.
Pension and Creditor Considerations:
Insurance and Guarantees:
In some cases, municipal bonds may be insured, providing a level of protection for investors. For example, Puerto Rico's Highway Transportation bonds were insured by Assured Guarantee, offering assurance to bondholders. However, it's important to note that muni insurance may not always work as expected, and investors should carefully review their options during debt restructuring processes.
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Municipal bond insurance
The insurance also enhances market liquidity for the bonds. While it does not guarantee a specific market value, bonds insured by highly-rated guarantors have historically maintained their trading value better than comparable uninsured bonds. Additionally, guarantors like Assured Guaranty have the resources to evaluate the unique risks of each issue and negotiate stronger terms and conditions, further adding to the appeal of insured municipal bonds.
In the context of Puerto Rico, the discussion of municipal bond insurance arises amidst the territory's debt crisis. Some investors in Puerto Rican bonds questioned whether their investments were implicitly insured by the U.S. government, given the weak macroeconomic fundamentals and surprisingly low-risk premium. The Treasury Put hypothesis suggests that investors expected a federal bailout due to past behaviour, which influenced their continued purchase of Puerto Rican debt despite the economic realities.
Assured Guaranty has been mentioned in relation to Puerto Rico's municipal bonds, with some investors seeking clarification on settlement options and others expressing concerns about restructuring. While municipal bond insurance provides a level of protection, it is important to recognise that it may not cover all scenarios, as highlighted by an investor who experienced challenges reaching Assured Guaranty and understanding the implications of bond restructuring.
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Risk of investing in Puerto Rico municipal bonds
Municipal bonds, also known as munis, are a popular investment opportunity. These bonds are issued to offset the capital expenses of municipalities or for special improvement projects such as schools or airports. They are publicly traded, leveraged closed-end bonds that sell a fixed number of shares.
Puerto Rico municipal bonds, or Puerto Rico muni bonds, are not just another muni. They are exempt from federal taxes and often exempt from state taxes for residents of the state in which they are issued. However, because Puerto Rico is not considered a "state", these bonds are not subject to the Investment Company Act of 1940, which was passed to prevent abuses of mutual fund and closed-end fund shareholders by requiring investment companies to disclose information about the financial health of the investment.
The Puerto Rican economy has faced serious challenges, and the risk premium for Puerto Rican bonds has remained surprisingly low given the doubts about Puerto Rico's ability to honour its financial obligations. In 2015, Puerto Rico began to default on some of its bond commitments, and bankruptcy was declared in 2017. This led to a major restructuring of $33 billion of liabilities against the Commonwealth of Puerto Rico, the Public Building Authority (PBA), and the Employee Retirement System (ERS), as well as more than $55 billion of pension liabilities.
Investing in Puerto Rico muni bonds carries risks. Firstly, the economic conditions in Puerto Rico have been very weak, and there are doubts about the territory's ability to honour its financial obligations. Secondly, the Puerto Rico muni bonds market has been characterised by fraud and misconduct, with many investors filing claims to recover their losses. Additionally, there is a risk of huge losses for investors if the muni bonds do not perform as well as anticipated, as an additional 5% can be leveraged for "special circumstances", which can cause up to 55% of the bonds to be leveraged.
Furthermore, the insurance status of Puerto Rico muni bonds is unclear. While some sources indicate that these bonds are insured, others suggest that the insurance may not always work. In the case of a default, investors may have to opt for a custodial trust structure established by the insurer, which may or may not provide the full face value of the bonds.
Overall, while Puerto Rico muni bonds offer certain tax advantages, investors should carefully consider the risks associated with these investments, including the economic conditions, the potential for fraud, the possibility of losses, and the uncertainty around insurance coverage.
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Puerto Rico's bankruptcy
In 2016, the Puerto Rico Oversight, Management, and Economic Stability Act, or PROMESA, was enacted. This legislation established a Financial Oversight and Management Board, tasked with overseeing Puerto Rico's budget and negotiating its debt restructuring. PROMESA enabled the island to initiate a bankruptcy-like process, providing protection from lawsuits and empowering the Oversight Board to make difficult decisions, such as instituting hiring freezes and selling off assets.
The Oversight Board played a crucial role in negotiating plans to reduce Puerto Rico's debt to sustainable levels. They separated creditors into groups based on their legal rights and claims, including bondholders and pensioners. In March 2017, the Board allowed the government to offer creditors a plan that would repay less than a quarter of the debts, sparking protests from residents. Despite opposition, the Board worked towards achieving consensual agreements in the best interest of all stakeholders.
The process culminated in March 2022, when a federal court confirmed a plan to reduce Puerto Rico's debt by 80%. This plan, crafted by the Financial Oversight and Management Board, limited the maximum amount Puerto Rico could borrow annually to $1.15 billion, equalling about 8% of the Commonwealth's revenues excluding federal aid. While this marked a significant milestone, the work of placing the Commonwealth on a sustainable fiscal path is ongoing.
Throughout this process, the role of bondholders and insurers has been a central issue. Some investors in Puerto Rican bonds believed that their investments were implicitly insured by the U.S. government, a concept known as the "Treasury Put." This perception may have contributed to the continued purchase of Puerto Rican debt despite the island's economic challenges. The resolution of bond-related matters, including insurance claims and restructuring, has been a critical aspect of Puerto Rico's bankruptcy proceedings.
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Frequently asked questions
Puerto Rico's municipal bonds are insured by Assured Guaranty, one of the top-rated municipal bond insurance companies.
Puerto Rico's municipal bonds have been rated below investment-grade since 2014, indicating a high level of distress or default. The Puerto Rican government began to default on some of its bond commitments in 2015 and declared bankruptcy in 2017.
The crisis has resulted in a restructuring of approximately $73 billion of outstanding bond debt, the largest-ever US municipal debt restructuring. It has also led to investigations into Puerto Rico's debt practices and factors contributing to the fiscal crisis.
