Puerto Rico still has the capacity to issue more than $3 billion in new debt, senior officials said Tuesday, adding that they hoped to tap the credit markets in March despite concern about whether the commonwealth can sustain its current large debt load.
In a conference call with investors on Tuesday, officials said the Puerto Rican legislature had proposed raising the commonwealth’s legal debt limit and proposed creating an independent authority, Cofim, that would issue secured debt on behalf of Puerto Rico’s municipalities. Puerto Rico had already created one such debt-issuing authority, Cofina, to help it through a financial crisis in 2006. But Cofina has used up its entire capacity and was downgraded recently.
Officials said the borrowing in March would consist of general-obligation debt, which is given a special, top-priority status by Puerto Rico’s Constitution. Much of the proceeds will be used to refinance existing debt, including $330 million owed to Barclays. The proceeds are also to be used to terminate interest-rate swaps, fill a $245 million hole in the current fiscal year’s budget and bolster the liquidity of Puerto Rico’s Government Development Bank, which orchestrates the commonwealth’s borrowing and tracks the complex payment schedules and cash flows of different branches of its government.
Officials of the Government Development Bank said the March borrowing would be the territory’s last during the current fiscal year, which ends on June 30. They also said this would be the last time the commonwealth would borrow to balance its budget, a practice that cannot be sustained in the long run.
Despite the risk, there is reportedly deep demand for fresh debt from Puerto Rico, especially among sophisticated investors seeking big returns. Hedge funds and other alternative asset managers believe they see ways of protecting themselves in the face of increasing risk that Puerto Rico’s other debt will have to be restructured at some point. But holders of Puerto Rico’s outstanding municipal bonds fear that special protections for the new lenders will push their own holdings back a place in line.
Whether and how much Puerto Rico can borrow is of intense interest, in part because the commonwealth’s high-risk profile means its new debt will most likely pay unusually high returns â€" a big selling point in the current low-rate environment. Market participants said they expected the new debt to pay at least 10 percent, which could translate into an after-tax return of nearly 20 percent for high-income investors in high-tax jurisdictions.
Because of its legal status, Puerto Rico can issue bonds that pay interest that is tax-exempt in all 50 states, at the federal, state and local levels.
“Judging from everyone we talk to in the high-yield space, there is tremendous demand,†said Tom Doe, chief executive of Municipal Market Advisors.
The rare tax provision has, in the past, generated tremendous demand for Puerto Rico’s bonds and allowed the commonwealth to amass an eye-popping debt burden relative to the size of its economy. By some measures it has $70 billion in outstanding debt. Both its economy and its population have been shrinking in recent years, trends that will make the debt difficult to repay unless they are reversed.
Investors said they thought the new debt might contain “acceleration†provisions, which would commit Puerto Rico to repaying it much more quickly if certain events came to pass. That would bolster investor confidence that they would be repaid, even if Puerto Rico’s severe financial problems led it to delay payment on other obligations.
In addition, they said the new debt could commit Puerto Rico to resolving any future debt-related legal disputes in United States District Court for the Southern District of New York, a venue considered more friendly to creditors than a court in Puerto Rico might be. Even though the constitution explicitly gives general-obligation bonds priority over all other expenditures, that provision has not been tested in court. Having a preselected court is an important detail to experienced investors in distressed sovereign debt, who cited the recent legal successes of investors in pressing Argentina to make good on its debt. Those disputes were adjudicated in federal court in New York
“The G.D.B. is currently inclined to accommodate such suggestions,†said José Pagán, interim president of the Government Development Bank, when asked about such special provisions in the conference call. Mr. Pagán added that such features would require legislative approval.
The possibility that the new debt would offer preference above the older debt troubled some market participants.
“What you’re looking at here are alternative investors looking at Puerto Rico through a very sophisticated prism,†said Robert Donahue, of Municipal Market Advisors, who focuses on Puerto Rico’s debt. “It would be naïve to think that these hedge funds are being altruistic. They have the upper hand in these negotiations.â€
He said the new debt might have a “double-barreled†structure, combining the commonwealth’s general-obligation pledge with a lien on some public asset, which would be a better security than the holders of ordinary general-obligation bonds have. If Puerto Rico tried to evade its obligations, creditors could then go to the preselected legal venue and seek enforcement of their claims.
“Existing bondholders who are not privy to these discussions are very concerned that the G.D.B. will get outwitted by these very experienced distressed investors,†Mr. Donahue said. “The last thing we want to see,†he added, are the municipal bondholders subordinated “by this set of investors who came in at the last minute.â€
Tuesday’s conference call came in the wake of downgrades by the three main ratings agencies, which all cut Puerto Rico’s general-obligation bonds to junk status. Officials said that they intended to follow through with existing plans to restore fiscal balance despite the downgrades. In addition to explaining their plans to borrow, they offered signs of encouragement to bondholders who hope the commonwealth will be able to fuel economic growth enough to pay its debts without incident. They said Puerto Rico had been shrinking the size of its budget deficit and would have a balanced budget in the 2015 fiscal year.
“We have reacted swiftly and decisively to address the many challenges that Puerto Rico faces,†Gov. Alejandro GarcÃa Padilla said on the conference call. “Politics have been left aside†in the process, he said. He cited public asset sales, stepped-up rates for water and other public services and budget cuts as signs of progress, but noted that the island’s financial troubles had been decades in the making.
Puerto Rico has had difficulty tapping the municipal market ever since last summer, when Detroit’s huge bankruptcy case rattled small investors and raised concern about the overall credibility of the general-obligation pledge. The markets have long treated an issuer’s “full faith and credit†pledge as unshakable, but Detroit stunned participants by putting general-obligation bonds into the same category â€" unsecured credit â€" as pensions and retiree health benefits for former city workers.
If Puerto Rico needs to restructure its debt at some point, it cannot use bankruptcy law as its legal framework because United States territories cannot declare bankruptcy. The framework for restructuring its debt would thus have to be the covenants written into the bonds themselves.
