Seven years ago, in the wake of a government shutdown caused by a $740 million budget deficit, Puerto Rican officials vowed to fix the island’s finances by 2010. Now investors are calling their bluff.
In the $3.7 trillion municipal-bond market, Puerto Rico and its agencies more than doubled their borrowing since 2004 to $70 billion this year. Even as the island’s population shrank and the economy contracted 16 percent since 2004, the government kept selling enough bonds to saddle each man, woman and child with $19,000 in debt.
Wall Street banks selling Puerto Rican bonds to mutual funds, money managers and individuals fueled the borrowing. Investors were lured by the debt’s tax-exempt status in all 50 U.S. states and yields above those on the mainland. In August, the binge collided with shockwaves from Detroit’s record bankruptcy and prospects for higher interest rates, sending tax-equivalent yields on the commonwealth’s bonds higher than those of Venezuela and forcing the island to turn to private lenders.
“We’ve lost credibility in the market,” said Sergio Marxuach, director for policy development at the Center for a New Economy, a nonpartisan research institute in San Juan, the capital. “We used all that money to finance current expenditures, to refinance debt that had little or no impact on the real economy.”
The plight facing Puerto Rico, which was ceded to the U.S. in 1898 after a war with Spain, affects almost anyone with a mutual fund invested in the muni market. Exempt from local, state and federal taxes, Puerto Rican bonds are held by 77 percent of muni funds, according to Morningstar Inc. (MORN)
About 180 funds representing more than $100 billion in assets, including those run by and OppenheimerFunds Inc., Franklin Templeton and Dreyfus, have weightings of 5 percent or more in Puerto Rico bonds, Morningstar said.
Neither a U.S. state nor a sovereign nation, Puerto Rico and its debt-issuing agencies, such as the Aqueduct and Sewer Authority, aren’t eligible to file for bankruptcy the way Detroit and Jefferson County, Alabama, have. It must pay its debts or default.
The island’s general-obligation bonds, which account for about 15 percent of its public debt, carry the lowest investment-grade rating by Moody’s Investors Service and Standard & Poor’s. A downgrade could force many funds to sell part of their Puerto Rico holdings, flooding the market. The debt has already lost 18 percent this year, the worst performance since 1999, according to S&P.
“Puerto Rico could represent a systemic issue for the municipal-bond market,” said Carlos Colon de Armas, an economist and former official of the Government Development Bank, known as the GDB. “We are now in a situation where the bonds are trading like junk. I think the ratings agencies have been careful not to lower the G.O.s further, to avoid creating havoc in the muni-bond market.”
Wall Street banks have been paid $880 million to manage Puerto Rico’s $120.3 billion in bond sales since 2000, according to Bloomberg data. The fees were based on an average cost of issuance of $7.30 per $1,000 face value. Citigroup Inc. (C) and its Salomon Smith Barney unit were Puerto Rico’s top bankers, managing $27 billion of issues, while UBS was second, with $25.6 billion, data show.
Though the island’s $29 billion total budget for the fiscal year that began July 1 relies on about $6.7 billion of federal funds, President Barack Obama’s administration isn’t moving to aid the commonwealth. Puerto Rican officials regularly brief the U.S. Treasury on the commonwealth’s liquidity, Treasury Secretary Melba Acosta said in an Oct. 15 webcast with investors.
“If there is any particular program to buy Puerto Rico bonds or to give certain financial assistance, we have not talked to them about that,” Acosta said. “There’s no discussions in regard to that.”
The U.S. Treasury also said it isn’t taking any special measures and is monitoring the situation within its domestic-finance office and by participating in the White House Task Force on Puerto Rico, according to Brandi Hoffine, a spokeswoman.
Puerto Rico still plans to sell as much as $1.2 billion of sales-tax bonds by Dec. 31 to balance budgets. If borrowing costs are too high, the commonwealth has enough funds to hold off on issuance through June 30, GDB officials said last week.
Bonds gained after the announcement, with yields on general-obligation securities maturing in July 2041 trading at an average of 8.38 percent on Oct. 17, their lowest in almost three weeks, data compiled by Bloomberg show. Ten-year Puerto Rico debt that is tax-exempt yields about 8.33 percent. That’s 13.79 percent on a taxable basis for investors in the top federal income bracket, exceeding the 12.7 percent average yield on Venezuelan dollar bonds.
Since taking office in January, Governor Alejandro Garcia Padilla, 42, has moved to strengthen Puerto Rico’s finances by raising the retirement age, requiring public workers to contribute more to pensions and boosting water and sewerage rates. The government collected about $1.7 billion in taxes in the July-to-September period, 5.4 percent more than a year earlier and $10.4 million above forecast.
‘Walking the Walk’
Garcia Padilla’s budget for the current fiscal year counts on $750 million of deficit financing, the smallest amount since at least 2009, according to the GDB, which handles the island’s capital-market transactions.
“They aren’t just talking the talk; they are walking the walk,” said Richard Larkin, director of credit analysis for Fairfield, Connecticut-based Herbert J. Sims & Co. Larkin, who said he’s been following Puerto Rican debt since 1977, advises his clients not to sell the commonwealth’s bonds. “If you own PR debt, you are going to get your money.”
The island’s government “has put in place a plan to strengthen the economy for the long-term,” Acosta, the treasury secretary, said in an e-mailed statement.
Padilla’s measures may not be enough to stem the island’s longer-term trends. Puerto Rico’s population has shrunk 4 percent since 2004 to 3.67 million, according to U.S. Census data. A six-decade decline in the birth rate is accelerating, with the number of newborns falling to 42,000 in 2010 from 60,000 in 2000, Puerto Rico’s statistics institute said last month. The population is heading toward a 100-year low by 2050, the institute said in a 2011 report.
More than a quarter of the population depends on food stamps, the Federal Reserve Bank of New York said in a 2012 report. Per-capita income of $15,000 is one-third the U.S. average, and a labor-force participation rate of 35 percent for those age 16 to 24 is among the lowest in the world.
With an unemployment rate of 13.9 percent, almost double the U.S. rate of 7.3 percent, emigration is increasing. People born in Puerto Rico are U.S. citizens and can move to the mainland without a visa.
“It’s a pretty broad cross-section of the population leaving, which includes everyone able to pay for a ticket,” said Jorge Duany, a professor at Florida International University in Miami who studies the island’s demographics.
Colon de Armas said Puerto Rico’s leaders haven’t done enough to make local industry competitive in the global economy and are instead counting on tax incentives or other assistance from Washington to protect businesses. The global slowdown and Detroit’s bankruptcy are less important, he said.
“We were in recession when the world was having good economic times,” he said. “It’s true that the world has had bad economic times recently, but we are uniquely depressed.”
Besides the economy, rising crime is also persuading people to leave. The homicide rate is about 27 for every 100,000 people, compared with the U.S. average of 4.7, according to 2012 data from the FBI.
Humberto Rivera, a 33-year-old lawyer, left Puerto Rico in 2010 to get a master’s degree in maritime law at the University of Miami and never went back, citing concerns about crime and the economy as he and his wife started a family. He spends time with a group of Puerto Ricans in Miami who all reached the same conclusion.
“Unfortunately, our reaction to whoever is in Puerto Rico and is asking us for advice on what they should do is, ‘Just leave, come over to the States; there are a lot more opportunities here,’” he said. The island needs a “reformation” to make it more attractive to young professionals, he added.
Puerto Rico’s economy is projected to grow 0.2 percent in the current fiscal year, according to the island’s Planning Board. A GDB index measuring economic activity fell 5.4 percent in August from a year earlier, the most since 2010.
For more than a decade, Wall Street has provided the cash to keep the island’s economy afloat even as its finances deteriorated. After Puerto Rico adopted a 7 percent sales tax in the wake of a government shutdown in 2006 that idled 100,000 workers, investment banks worked with the commonwealth to create a new class of debt backed by a portion of the new tax.
The following year, Puerto Rico sold $4 billion of the debt through Goldman Sachs Group Inc. and UBS AG (UBSN) in its biggest-ever municipal deal, allowing it to borrow at 4.9 percent for 50 years. Money raised in the offering was used to repay loans owed to the GDB that plugged prior budget deficits.
Tiffany Galvin, a Goldman Sachs spokeswoman, declined to comment.
Puerto Rico now has $15 billion of the debt, known by the Spanish acronym Cofina. The commonwealth has also issued more than $3 billion of debt to fund its pension system, borrowed more than $1.4 billion against its share of a 1998 national settlement with the major tobacco companies and put its main airport and a major highway into long-term lease agreements.
“They’ve leveraged every single revenue stream out there that they can leverage,” said Marxuach.
UBS this month said it put one of its 130 advisers in Puerto Rico on leave while the bank reviews loans issued to clients. The move came after a brokerage client said he was given credit to buy funds holding the island’s government debt. The practice amounted to “throwing gasoline on an open fire,” said Jacob Zamansky, a securities arbitration attorney who says he represents 60 UBS clients in Puerto Rico.
Karina Byrne, a UBS spokeswoman in New York, said there’s nothing wrong with using a margin loan to buy a muni-bond fund. The person who was suspended improperly advised his clients to take out a “non-purpose loan,” she said. Clients are forbidden from using those credit lines to buy securities, Byrne said.
“As soon as this information about non-purpose loans came up, we immediately opened up an internal investigation,” Byrne said.
The triple-tax exemption on Puerto Rican bonds created built-in demand, particularly from investors in states where the supply of local debt is scarce. Before the financial crisis, some investors also believed the federal government would never let the commonwealth default, said Bart Mosley, co-president of Trident Municipal Research in New York.
“You had this artifice that created liquidity at borrowing costs that were probably much lower than they otherwise would have been,” said Mosley.
Among mutual-fund managers, one of the biggest losers has been OppenheimerFunds, a unit of Massachusetts Mutual Life Insurance Co. Twelve of the 20 mutual funds with the biggest percentage of Puerto Rico holdings are offerings of the New York-based firm, according to an Oct. 17 report by Morningstar. Twenty of Oppenheimer’s funds had an average loss of 8.9 percent from May 1 to Oct. 1, Morningstar said.
On Oct. 9, Massachusetts’s chief securities regulator, William Galvin, said he was investigating the impact of Puerto Rican debt on the state’s mutual-fund advisers.
Puerto Rico’s constitution guarantees that holders of general-obligation bonds are paid before any other creditors, said Dan Loughran, a portfolio manager with OppenheimerFunds.
“Bond issues on Puerto Rico have very strong legal protections,” Loughran said. “They have the ability to pay and the very strong willingness to pay.”
Larkin of Herbert J. Sims & Co. said the current and previous governments haven’t gotten enough credit for taking the right measures to get the economy back on track. Yet he said he agreed with critics who point out the government has failed on earlier promises to get its financial house in order.
The borrowing binge has slowed, though it hasn’t stopped. Morgan Stanley in August managed a $673 million sale of bonds by the Electric Power Authority, $73 million more than originally planned. The highway authority also borrowed $400 million in August at a rate that peaks at Libor plus 11.4 percentage points. The Royal Bank of Canada managed the sale.
Elisa Barsotti, spokeswoman for RBC, declined to comment on the sale. Lauren Bellmare, a Morgan Stanley spokeswoman, declined to comment.
Even Puerto Rico’s underwriters said that for years the island government hadn’t kept its promises to shore up its finances. At a May 2012 investor conference sponsored by the GDB, representatives of banks that had issued billions of Puerto Rico’s bonds said the commonwealth had to reduce its debt.
“Market access is based on confidence,” said Peter Bartlett, co-head of Citigroup’s municipal trading and sales department. “Confidence is a tricky thing. It can change very quickly.”
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