Dear Investors,
Earnings season is almost over and has been a very busy time as usual. There are a lot of positive developments occurring with most of our investments. Some of this has been obscured by global concerns over Turkey and emerging markets, but over time the fundamentals of the businesses themselves are what matters.
Some of our most important investments are in the bond insurance space including AGO, AMBC, and to a lesser extent MBI and SYCRF. In addition, many of our accounts have exposure to Puerto Rico bonds bought darn near the lows in December of 2017. Keep in mind that we had not bought any Puerto Rico bonds in the years before, as we are very careful about credit risk via strenuous fundamental analysis. Below are a few of the major developments, all of which augur positively for us barring any new hurricane disaster or major congressional changes:
On August 8th, Puerto Rico’s government and oversight board announced that they had reached an agreement in principle with holders of the COFINA sales tax bonds. The senior bondholders and the insurers would realize a recovery of roughly 93 cents on the dollar. The junior bonds would realize a recovery just under 60 cents. To put this into perspective, we bought junior COFINA bonds in December at between 8-12 cents, making for one of our best returns ever at around 500% in 9 months. Obviously, we wish we would have bought a heck of a lot more of these, but we didn’t want to buy in too much size due to our already large exposure to Puerto Rico via the insurers. Often it pays to buy into enormous pessimism when everyone thinks you are acting most foolish.
This was such a major development because the oversight board and government of Puerto Rico have for months refused to engage with creditors on consensual negotiations, despite that being the primary goal of Promesa. The tides seemed to change when Rep. Rob Bishop filed an amicus brief on behalf of Ambac with the First Circuit Court of appeals, discussing the intention of Promesa to respect creditor rights, which had thus far been trampled on. Previous letters to the Oversight Board didn’t seem to have the same impact but the law has always been on the side of respecting property rights, which is one of the fundamental pillars that has made the United States the economic marvel it has been for the last 242 years or so.
Another significant factor that has led to increased negotiations is the remarkable resilience shown by the economy of Puerto Rico, despite the absurdly low projections forecasted by Puerto Rico’s crack-team of economists (I must say I have engaged with a few of them on Twitter and I’m happy to have been right ha ha). The oversight board was essentially gaming the system, by making their fiscal plan revenue projections so low that paying debt off would be extremely difficult. Then, politically-charged “economists” would write editorials explaining how Puerto Rico simply could not pay any debt. None of these articles ever stated that the constitutions of PR and the U.S.A. prohibit this, as do all of the legal contracts and Promesa.
Puerto Rico’s Economic Activity Index has increased for seven consecutive months as government aid and insurance disbursements have boosted economic activity. Incredibly, the Commonwealth announced that it had collected roughly the same amount of revenue during FY 18 (ended June 30) as it had in FY 17. This is an unbelievable outcome given that much of the island was without electricity for a large portion of that period. Things are likely to get much better, which is good news for those on the island!
The First Circuit ruled that PREPA’s bondholders, as well as AGO and MBI, have the ability to refile their motion for the appointment of a receiver to protect their collateral as they are entitled to do under the utility’s bond indentures. The Title III Judge Swain had earlier denied the creditors’ motion to have a receiver appointed, but the First Circuit overruled her interpretation. This should likely lead to a consensual agreement on the PREPA debt, which is very important for MBI and AGO.
There is already a consensual settlement with some creditors that would call for reasonable losses, but I’d expect the numbers to get much better. I believe it is likely we will see further overruling’s of Swain in the appeals court, which will continue to turn the legal tides further towards protecting property rights. If a receiver is appointed at PREPA, the utility will be able to raise electricity rates to generate more revenue to cover debt service. It could also improve the efficiency of the operation, which is the biggest problem in that it simply gives away a massive amount of electricity. Even worse, the utility has been used to give plush jobs as political patronage to the ruling party.
If COFINA and PREPA get worked out, the path becomes much easier to resolve the restructuring of Puerto Rico. The biggest issues remaining would be the GO debt, which has some of the highest legal protections of any debt I’ve ever seen. I think the market is dramatically underappreciating how strong recoveries will be on those issues. Another large exposure is the Highway Authority debt, which are revenue bonds. The situation on HTA debt is clouded by a “clawback” on some of the revenue, which can only legally be diverted to pay GO debt. Instead, the government of Puerto Rico and the Oversight Board have simply not paid any of it. I expect the appeals court to address some of the major issues on these credits in favor of creditors.
The bottom line is we have seen nice moves in all of these stocks upwards. It also has allowed us to lock-in a lot of profits on many of our sold put options. Once we have made the majority of the profits on a given put, we generally like to exit them to pursue the most attractive utilization of that capital on the next investment. Some of these positions were quite large, so while we love them, we are very cognizant about our concentrations. As we saw last year during hurricane season, anything can happen in this world and we only can control so much, so often prudence is just as important as valor.
We will keep you updated as things develop, and I have many other updates on other key positions that I’ll do my best to put out as time permits. As always, please don’t hesitate to give us a call if we can ever be of assistance! I’d like to also say thank you for the referrals of friends and family that we have received over the years. At T&T, we really don’t do much marketing so I’m proud of our growth and our long-term client base. It really provides us with tremendous satisfaction to have a role in improving you and your families’ financial lives, and it is a responsibility we will never neglect or take for granted!
Sincerely,
Tim Travis