The municipal bond market is not as glamorous as something like Bitcoin, but it sure is essential for all of us. When our cities build schools or roads, they generally don’t pay for them via a cash surplus. These public functions are financed through bond issuances backed by promises and pledges. For something like a school, the debt service is usually financed via property or other taxes. For something like a toll road, the revenues generated are often security for the credit lenders. This is really finance 101 and is the backbone of western civilization to some extent.
How much harder would it be to buy a house if we couldn’t get a mortgage? Most people wouldn’t be able to qualify for a mortgage if the lender couldn’t use the collateral as security. This is why you can borrow now for 4%. Credit card debt is unsecured, which is why rates are often in the high-teens.
Many of the bonds issued by Puerto Rico are revenue bonds. In all municipal bankruptcies, revenue bond pledges have been upheld as valid. This generally has put a floor on the haircuts taken in various restructurings including Detroit, Jefferson County, etc. It really just depends on what amount of debt service the revenues can support.
Outside of revenue bonds, the other major type of credit issuance of municipalities are general obligation bonds (GO). GOs have always been seen as a pillar of strength because they were backed by the full taxing capabilities of a municipality. Generally, the debt service payments become before non-essential services and even pension obligations. The strength of these pledges is why municipalities can issue debt at such cheap prices. Since tax payers are the ultimate users of public works, the cost savings on the debt service is absolutely essential. More expensive debt increases the tax burden and weakens the financial stability of a municipality, leading to things like higher taxes, layoffs, and pension cuts.
The reason why this is so relevant today is that the restructuring of Puerto Rico is by far the largest we have seen in the municipal finance market, and its ramifications will last for decades. Congress created the PROMESA legislation to address the debt, because a typical Chapter 9 municipal bankruptcy is not allowed for a commonwealth. PROMESA specifically says that preexisting pledges must be respected and that one of the requirements of a restructuring is allowing Puerto Rico to access capital markets once again.
Congress and the President appointed an Oversight Board to supposedly instill fiscal discipline to the island and to basically represent the government of Puerto Rico. The Oversight Board will create a fiscal plan and then a plan of adjustment, which would then go before Judge Swain. Judge Swain would either approve or reject the plan based on it accordance with applicable laws.
The Oversight Board has taken a very unfriendly approach to creditors thus far. It is very likely that this is a negotiating tactic to procure bigger haircuts, because on the basis of the law, the creditors position is extremely strong. While there is no doubt that some investors have bought into the debt at 25 or 50 cents on the dollar, many creditors have owned the debt for years. The bond insurers’ that we own have been supporting Puerto Rico for decades to obtain lower financing costs and get infrastructure built.
The Oversight Board appears to be creating extremely draconian fiscal plans, which provide little to no money for debt service for the first five years. They include a slush fund for miscellaneous expenses and don’t account for any money coming from Medicaid, despite it already being provisioned by the U.S. government’s budget. This will be followed by an equally bad plan of adjustment that will likely be rejected by the Judge where the real negotiations will then commence.
Creditors have a great deal of power because of their legal position and if laws aren’t respected, they can ultimately take it to the Supreme Court. Nobody in their right mind would invest in Puerto Rico if it is clear that the government has no intention of honoring its promises and agreements. Puerto Rico needs investment to grow and to improve its standard of living. The hurricane certainly had a devastating short-term financial impact but the long-term is likely to be much brighter. According to Moody’s Analytics, government aid and insurance payouts actually eclipsed the economic losses suffered during Superstorm Sandy and Hurricane Katrina. I’d expect a similar dynamic with Puerto Rico.
When you hear politicians advocate for wiping out creditors and complain about vulture investors, it is important to remember that capitalism and the rule of law, are arguably the biggest reasons that our quality of living has improved so much since the dark ages. Everybody has enormous compassion for the people of Puerto Rico that are still struggling without electricity, but less understood is the level of corruption and incompetence that created the utility so inefficient that power could not be restored even after all this time has passed. If a government no longer has to abide by the promises that they make for a short-term benefit, than you can expect more government waste and a far worse overall quality of living. Nobody is asking for a bailout by any means but the rule of law must be respected.
For those of you interested in some of the major issues being argued in Puerto Rico, I’d encourage you to read the article linked below. In a municipal bankruptcy, the creditors really have no leverage until the plan of adjustment is argued before the judge. This is why just about all of the news is negative until that occurs.
In Detroit, the original plan of adjustment for the UTGO bonds was a 20 cent recovery. This was reduced to 10 cents as the situation looked more dire. As creditors enforced their rights, ultimate recoveries were in the mid-70s.
Reasonable haircuts would save Puerto Rico billions, while allowing the island to attain access to capital markets once again, as long as laws are respected. For the bond insurance companies that we invest in, worst case scenarios are priced in. Many market participants are shorting the stocks or buying credit default swaps on them to hedge bond positions in Puerto Rico. Once this situation is resolved, I believe we are going to see huge gains on these investments. While we all wish it could happen more quickly, the situation should be resolved in 12-18 months.
Many investors I’ve talked to are concerned like I am that the general stock market is overvalued. Understand that every investment that we are making is done with the knowledge that this is likely the case so we are being very disciplined and conservative. Many of our investments like the bond insurance stocks, are special situations. They aren’t going to rise or fall with the overall markets as much, but instead will be dictated by the resolution of specific major events such as the Puerto Rico restructuring. This is one reason I feel we could potentially post double-digit returns on average annually, even if the markets are flat to negative. We also utilize strategies such as selling puts on value stocks. This reduces our upside potential when there is a large rally like the S&P has seen this year, but it provides a great deal more safety as markets pull back.
This year has been unique in that we haven’t seen a major selloff but as value investors, we get aggressive when markets are cheap and conservative when they are expensive. When big selloffs do occur, you can’t create the same type of hedges one can create in more normal environments. Predicting when the selloff occurs is virtually impossible, so the key is maintaining that deep value discipline and not getting caught up following sheep to slaughter!
Thank you and if you have any questions, please don’t hesitate to give me a ring!
Commentary How the Puerto Rico dispute threatens bond holder rights
Sincerely,
Tim Travis