Puerto Rico Muni Bond Update: Moving Right Along
Rochester Portfolio Manager Dan Loughran discusses the merits of Puerto Rico muni bonds.
- While there are investment risks, we continue to believe in Puerto Rico and its bonds.
- We believe Puerto Rico’s plan to balance its budget is on track.
Aired: January 17, 2014 on CNBC
Host Kelly Evans: Welcome back. Well, it's massive – the $4 trillion U.S. muni market, a big source of income for a lot of retail investors, probably many of you watching right now. That market is facing some major headwinds, and one, in particular, the threat from a small island of Puerto Rico with nearly $70 billion in public sector debt, and concerns are growing the country won't be able to—not country… the territory?
Host Bill Griffeth: Territory, yeah.
Host Kelly Evans: Won't be able to repay it.
Host Bill Griffeth: So, how worried should investors here in the U.S. – be worried about a possible Puerto Rican debt default. Joining us to talk about it: Larry McDonald, the Senior Director of NewEdge; Doug (Dan) Loughran is the Senior Portfolio Manager at OppenheimerFunds; and also with us is our own Michelle Caruso-Cabrera. Michelle, you've done some reporting on this. Put it in perspective. What's the possible threat of default? How real is it?
CNBC Correspondent Michelle Caruso-Cabrera: The possible threat of default, it really depends on issuance to issuance. Puerto Rico has so many different flavors of bonds, and you really don't know, if there's a restructuring, how it's going to play out. I would say though if you hold a U.S. muni bond fund here in the United States, you probably have exposure to debt from Puerto Rico, and here's why: Here are the numbers from Morningstar. Of all the municipal bond funds in the U.S., 69% hold at least some exposure to Puerto Rico. That number is down from several months ago. It used to be 75%. Why is that? Because there's a triple exemption from Puerto Rico. You don't pay federal, you don't pay local, you don't pay state tax on revenue you get from a Puerto Rico bond no matter where you live in the United States. So, if it's yielding 8%, wow, you'd have to get 12% in something that's taxed to get the same kind of return. So, a lot of funds have bought Puerto Rico over the last several years.
Host Kelly Evans: Yeah. And, Dan, you know, I'm curious, a lot of people were looking to Puerto Rico to juice returns in muni bond portfolios. What has been done since these concerns really first aired last year to ensure that the risks aren't there for investors who don't want to be exposed?
Rochester Portfolio Manager Dan Loughran: Well, the bonds themselves have very strong legal protections. When you're talking about the general obligation bonds—and Michelle is right: there are many different types of issue on the island—general obligation bondholders have a constitutional protection. The constitution of the Commonwealth places debt service on those bonds first ahead of any other expenditures, ahead of any other pension payments, for instance, or any vendor payments. It's a really strong legal position to be in. Furthermore, the territory is not eligible to file Chapter 9 bankruptcy, nor can any of the agencies on the island that issue debt.
Host Kelly Evans: But, Dan, we're up against the limits of feasibility here. I mean, I understand why they prioritize investors, but at some point they simply won't be able to service the debt.
Rochester Portfolio Manager Dan Loughran: Well, you know, let's talk about that. Because of that constitutional hierarchy, GO bondholders have nine times debt service coverage ratio. Their general fund budget will be about $9.7 billion this year, and debt service coverage requirements is about $1 billion. Furthermore, their plan to ultimately balance their budget is right on track. Halfway through the fiscal year they're right spot-on where they want to be. They're anticipating their total revenues to be a billion dollars higher than last year, so there is concern about their ability to pay. I believe it's there, and they've always shown a strong willingness to pay. We heard again this week how the government said, ‘We're going to do what it takes to honor all of our debts in the bond market.’
Host Bill Griffeth: Larry, are you concerned? Should muni bondholders in Puerto Rico be concerned
NewEdge’s Larry McDonald: Well, keep in mind the bonds are down 30 points on the year over the last maybe 18 months.
Rochester Portfolio Manager Dan Loughran: Well.
Host Bill Griffeth: I'm talking to Larry now, Dan. Hang on.
Rochester Portfolio Manager Dan Loughran: Yeah, I'm sorry.
NewEdge’s Larry McDonald: So, they've factored in a good part of it, a muni default. But the big thing is the senate president of Puerto Rico, Mr. Bhatia, reached out to me last week and he mentioned that constitutional protection. And I did some research, and it's true, some of the bonds, they have $70 billion of debt, you know-- five times [that of] Detroit. But of that $70 billion, only 64% are constitutionally protected, so not all of the bonds are constitutionally protected, and that's one of the things that investors have to know.
Host Bill Griffeth: Meaning?
NewEdge’s Larry McDonald: Meaning, that out of the $70 billion that some of the bonds don't have that.
Host Bill Griffeth: They could in fact default?
NewEdge’s Larry McDonald: Yeah, don't have that protection. Another thing to watch for this year, one of the black swans that nobody is talking about is what's called GASB 68, G-A-S-B 68 and 67. It forces pensions in states like Illinois, Puerto Rico territory to take a risk adjusted rate of return. So, a lot of these pensions are assuming like 7%, 8% assumed return, but that's not a risk adjusted return. The new regulations are going to put that down to about 4%, which means that Puerto Rico's obligation on their pension goes from $32 billion up to $38 billion; it spikes. In the case of Illinois--
Host Kelly Evans: Do we know who owns this debt? Has there been a rotation from the retail community
CNBC Correspondent Michelle Caruso-Cabrera: Dan, Dan owns tons of it, Kelly. He's the guy with the most of it. When you look at all of the funds that Morningstar has out there, Dan's got the biggest exposure. I mean, are you worried? Everybody else is on the other side of the street compared to you, Dan.
Rochester Portfolio Manager Dan Loughran: Keep in mind that between $25 billion and $30 billion in bonds are owned by retail individual investors in the bonds directly themselves. So, they're widely held not only among the funds, but individual investor, and the hedge funds now, the smart money have been buying. That's actually driven up the prices so far in this year-to-date. Long GO bonds are up 7%.
Host Bill Griffeth: What about the 36% of the Puerto Rican bonds that Larry was just talking about that don't enjoy that constitutional protection that you were just alluding to?
Rochester Portfolio Manager Dan Loughran: Yes, thank you.
Host Bill Griffeth: Do you know if you own any of those bonds?
Rochester Portfolio Manager Dan Loughran: Yes, yes, thank you. Some of those are revenue bonds that have strong protections ring-fenced by themselves. Look at the bonds that are known as COFINA. Those are the bonds that are backed by sales taxes. They don't have the constitutional protection, but right now they have close to two times debt service coverage on all bonds including senior and subordinate.
Host Bill Griffeth: Okay.
Rochester Portfolio Manager Dan Loughran: So, that means sales taxes have to fall by half before there's not enough money to pay them.
CNBC Correspondent Michelle Caruso-Cabrera: Could I raise one point?
Host Kelly Evans: Yeah. Michelle, as you do, I also wanted to ask you about this. Look, we all know the status quo for the way this is supposed to be handled, but we've also witnessed the example of Europe in which, you know, it seemed as though they were often deciding this on a case-by-case basis…
CNBC Correspondent Michelle Caruso-Cabrera: So, I don't mean to contradict you, but this is the point that I was going to bring up. We actually don't know the status quo because that's the issue with Puerto Rico.
Host Kelly Evans: Oh, well, that doesn't help. Yeah.
CNBC Correspondent Michelle Caruso-Cabrera: It is neither fish nor fowl. It is not Greece, it is not Detroit. We don't know what a bankruptcy looks like. That's the issue. So, a lot of distress, attorneys who work in distress, are trying to figure out what on earth would happen here. It's not really clear. People wonder, could they change the constitution the way Greece went and changed its laws retroactively to screw bondholders? Could they do the same thing in Puerto Rico?
Host Bill Griffeth: Larry.
Rochester Portfolio Manager Dan Loughran: Good point. And right now it is not a Latin American sovereign, it is a territory of the United States of America. So it's a good position to be in now.
Host Kelly Evans: Okay. Larry, what about what Dan was saying about those bonds that are not covered or, you know, how real a threat is that?
NewEdge’s Larry McDonald: Well, it's fascinating. I mean I've been in the distress business many years. Special shout out to ACG Analytics, my partner in Washington that advises me. We've been advising hedge funds. The interest that we've seen the last 10, 15 days from Puerto Rico, from institutional accounts is spectacular. So there's a lot of people looking at Puerto Rico credit, but from a long-term perspective, remember one thing: Every day 92 people leave Puerto Rico. Every single day. Their population has gone from, say, 3.9 million people down to 3.6 in the last 10 years. It's completely not sustainable. Their tax laws—Microsoft for example paid like 1% tax there a couple of years ago—so their tax laws are really not effective for keeping the population.
Host Bill Griffeth: Let me take you to the bottom line. For those people who own OppenheimerFunds or themselves own some general obligation bonds out of Puerto Rico, should they be concerned about the possibility of default right now?
NewEdge’s Larry McDonald: Short term, I think they get this deal done in February, I think the bonds are going up because the market notes it's a third lien bond. So they're actually doing a third lien bill on the COFINA revenues, a third lien which is very unusual. That deal probably gets done so the bonds will get a rise, but I think late in the year there's a black swan with, like I said, this GASB 68. It really makes it difficult for Puerto Rico. I think people should be concerned about a default late in the year.
Host Bill Griffeth: All right. Well, we'll revisit this I'm sure at some point. Thank you all for your thoughts on this.
Rochester Portfolio Manager Dan Loughran: Thank you.
CNBC Correspondent Michelle Caruso-Cabrera: Thank you, guys.
The views expressed by OppenheimerFunds portfolio managers represent the opinions of OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict performance of any investment. These views are as of the date of this interview and are subject to change based on subsequent developments. Past performance does not guarantee future results.
Municipal bonds are at risk of default and loss of principal. Fixed-income investing entails credit and interest rate risks (when interest rates rise, bond/fund prices generally fall).. A portion of a municipal bond fund’s distributions may be subject to tax and may increase taxes for investors subject to federal alternative minimum tax; however, income distributions from Rochester’s two AMT-free funds will not increase an investor’s exposure to AMT. Capital gains distributions are taxable as capital gains.
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