The long-awaited default
Puerto Rico defaulted on its debt this week for the first time in history, a development that was dramatic but widely expected. The U.S. territory owed $58 million by Aug. 1 to creditors of the Public Finance Corporation and paid just $628,000. The default has generated a lot of attention from the media but no extreme reactions from the municipal market. That’s likely because most observers say there shouldn’t be a ripple effect across the municipal market based on what happens in Puerto Rico. It’s a contrast to what happened in Michigan after Detroit defaulted on its debt. Detroit's financial crisis impacted all of southeastern Michigan because the city was the economic center of that area.
Another big reason the municipal market is mum may be that they're bracing for more. As Emily Raimes, vice president at Moody’s Investors Service noted this week, Puerto Rico’s legislature didn’t even appropriate the debt service for the corporation bonds. "The lack of appropriation," she said, "means there is not a legal requirement to pay the debt, nor any legal recourse for bondholders. ... This is a first in what we believe will be broad defaults on commonwealth debt.”
Lastly, Puerto Rico isn't allowed to file for Chapter 9 bankruptcy, but that isn’t stopping the island from acting like it's bankrupt. All of its recent filings proposing debt restructurings for its major agencies include a moratorium on paying debt for up to five years in order to pay for operating and capital expenditures that the territory desperately needs. (Puerto Rico has about $72 billion in debt and a less than $10 billion operating budget.)
You’d think a default of this magnitude would be a wake-up call, but even with all the financial pressure and over-borrowing, it’s not clear Puerto Rico has learned its lesson.
The proposal to restructure the Puerto Rico Electric Power Authority’s debt calls for issuing $1.1 billion in new-money securitization bonds to help fund capital investments. The proposal assumes Puerto Rico will pay an interest rate of just 6 percent to the investors of those bonds, which is unrealistic for a government with a credit rating that’s deep into junk status. (Last year, when Puerto Rico’s credit rating was at junk status but still higher than it is now, it issued bonds at an interest rate around 9 percent.)
Repayment on these bonds also has a pretty rosy outlook. The payment stream would come from a separate charge on ratepayer bills -- ratepayers who are already being taxed to the limit and fleeing the island because of their government’s borrowing.
So about that default...
Two more interesting items came out this week regarding municipal defaults and bankruptcies. One is from Municipal Market Analytics (MMA), which reminds investors that muni defaults are still very rare “despite a very small number of high-profile defaults that garner a lot of media attention.” The other item is an analysis from Moody’s that says the stigma of Chapter 9 bankruptcy may be fading among local governments. (Incidentally, I wrote about that exact idea a couple years ago.)
On the first item: Muni defaults are still extremely rare. Over 10 years, the percent of municipal governments (excluding housing agencies) that have defaulted on debt has averaged less than a quarter of a percent, according to Moody's. Meanwhile, the average corporate default rate over the same period was 11.58 percent. Still, MMA partner Matt Fabian encourages investors to limit their investments to only muni bonds that are rated by credit ratings agencies. A big reason for this is because few issuers will want to pay ratings agencies for an evaluation if they think they’ll be rated below investment grade. So, Fabian said, “as a result, riskier sectors tend to have more non‐rated issues.” But there is still a reason to be concerned about rated debt and that's because the percent of local governments rated at junk status has doubled between 2011 and 2014. He expects there will be more defaults of rated credits in the coming years thanks to continued spending pressures. “Some issuers may reach a point in which there is not enough money to pay its liabilities in full and provide adequate services to its citizens,” Fabian writes.
Secondly, Moody’s new report, called “Municipal Bankruptcy Still Rare, but No Longer Taboo,” notes that the bankruptcies of Jefferson County, Ala.; Stockton, Calif.; and Detroit “lay out a potential blueprint [that] other distressed municipalities could follow.” But just because something is perhaps less taboo doesn’t mean credit ratings agencies will go any easier on these distressed cities -- particularly given the fact that most of the recent bankruptcies have favored funding pensions over fully paying back bondholders. “The willingness to consider bankruptcy often means the interest of issuers and creditors have become diametrically opposed, which must be reflected in the rating,” said Moody’s Senior Vice President Al Medioli.