Muni Credit News February 4, 2016

Joseph Krist

Municipal Credit Consultant


The Working Group for the Fiscal and Economic Recovery of Puerto Rico released details of a comprehensive voluntary exchange proposal presented to advisors to the Commonwealth’s creditors last week. The proposal seeks to reduce the Commonwealth’s mandatorily payable tax-supported debt and near term debt payments. The implementation of the expense and revenue measures in the FEGP – totaling approximately $20.6 billion in revenue increases and $13.8 billion in expenditure reductions over the next ten years – are projected to reduce the Commonwealth’s projected cumulative fiscal deficit for the next decade to approximately $34.0 billion.

A voluntary exchange offer is intended to restructure more than $33 billion of payments due over the next ten years on its tax supported debt to allow the Commonwealth make its tax-supported debt sustainable. The plan provides for the Commonwealth to institute a fiscal control board to provide necessary oversight and ensure the Commonwealth complies with the FEGP and the terms of the exchange offer.

The restructuring proposal contemplates that creditors will exchange their existing securities for two new securities: a “Base Bond,” with a fixed rate of interest and amortization schedule, and a “Growth Bond,” which is payable only if the Commonwealth’s revenues exceed certain levels. The new securities would also provide creditors with enhanced credit protections, such as a Commonwealth Guarantee and statutory liens and pledges with respect to certain revenues. Enhanced credit support would include a statutory lien on and pledge of the 4.5% sales and use tax (“SUT”) and up to approximately $325 million annually of petroleum products tax revenues.

Under this proposal, the $49.2 billion of tax-supported debt would be exchanged into $26.5 billion of newly issued mandatorily payable Base Bonds (a 46% haircut) and $22.7 billion of newly issued Growth Bonds. Interest payments on the Base Bonds would begin in January 2018, scaling up to 5% per annum by FY 2021, when principal payments would begin.

The Growth Bonds would be payable only to the extent the Commonwealth’s revenues exceed its current baseline projections as a result of real economic growth on the Island. The first such payments, if any, would be made beginning in the tenth year after the close of the exchange offer. In any given year in which the Growth Bond would be payable, creditors would receive payment of up to 25% of such revenues. The proposal also seeks to lower the Commonwealth’s debt service-to-revenue on tax-supported debt to approximately 15%, a level consistent with the debt limit contemplated by the Commonwealth constitution. At 15%, Puerto Rico would still remain at levels exceeding the most heavily indebted of the U.S. states. Debt service on the Base Bonds has been structured to give the Commonwealth the opportunity to further reduce that ratio as a result of economic growth and develop into a stronger credit over time. A successful exchange offer, along with the implementation of the measures recommended in the FEGP, should improve the Commonwealth’s credit-worthiness, and, if the Commonwealth’s economy is able to grow in line with the growth assumed for the United States, investors will be able to recover the full principal amount of their investments through payments on the Growth Bonds.

The exchange offer is predicated upon a number of key assumptions, including very high participation levels from the creditor groups as well as the U.S. Federal Government maintaining at least its current percentage levels of programmatic support for the Commonwealth. If very high participation levels cannot be achieved or the U.S. Federal Government allows the level of programmatic support for Puerto Rico to materially decline, then the terms of the exchange offer will have to be revisited and creditor recoveries adjusted accordingly.

A serious proposal would accept the need for outside oversight. It can be argued that the Commonwealth has forfeited the trust of its various stakeholders to oversee its own recovery. The continuing lack of audits, reliable ongoing revenue collection reporting, and the lack of urgency with which these matters have been addressed all convey a serious lack of purpose. The risks to bondholders are basic and clear. Primary among them is that the plan assumes that the Commonwealth can reverse years of negative economic growth in the face of steady declines in population especially among the more educated and skilled segments of the population.

The effective five year moratorium in principal repayment is in line with the Commonwealth’s attempt to pose the situation as an us vs. them (as in the hedge fund investors) situation which has always been a convenient oversimplification of the situation. The size of the proposed haircut and the economic risk sharing aspects of the proposal are in line with an effort to align the various interest groups behind a Congressional bailout.

The plan continues the strategy of delay which the Commonwealth has been employing as it seeks a federal solution. It comes on the heels of a failure by island politicians to approve a PREPA restructuring which might require power users to actually pay for power. At the same time, the proposed interest rates contemplated in the tax-backed restructuring seem quite unrealistic in the face of the yields being demanded by the market for the Chicago Public Schools deal postponed from last week. Hence our view that this current proposal is preliminary at best and a mere stalling tactic for the Commonwealth.


At the same time Puerto Rico is offering its debt restructuring proposal, Sen. Elizabeth Warren, D-Mass., filed an amendment to an energy bill pending before the Senate to include a provision that would temporarily halt litigation over Puerto Rico debt until April 1. If the amendment is passed as part of the energy bill, it would put a stay on any creditor litigation filed on or after Dec. 18. Warren’s effort to include the amendment has support from Sens. Blumenthal, Schumer, and Menendez, co-sponsors of the legislation, as well as Sens. Kirsten Gillibrand, D-N.Y., Chris Murphy, D-Conn., and Bill Nelson, D-Fla.

The amendment asserts that as Puerto Rico continues to deal with roughly $70 billion in debt, “a temporary stay on litigation is essential to facilitate an orderly process for stabilizing, evaluating, and comprehensively resolving the commonwealth’s fiscal crisis.” A stay would avoid a disorderly race to the courthouse, benefitting creditors and other stakeholders, and will only be temporary, according to the proposal.

The April 1 deadline for the stay happens to line up with a late December directive House Speaker Paul Ryan, R-Wis., gave to House committees with jurisdiction over Puerto Rico to create a “responsible solution” for the commonwealth by the end of March. Assured Guaranty Ltd., Ambac Financial Group Inc., and Financial Guaranty Insurance Co. have all filed lawsuits in January, during the time period that would be covered by the moratorium. A judge has consolidated the insurers’ cases in the U.S. District Court for the District of Puerto Rico.

The House Natural Resources Committee held a hearing this week that may lead to legislation designed to aid Puerto Rico. Pedro Pierluisi, Puerto Rico’s sole representative in Congress and a member of the committee said he supports creating an independent board to approve things like Puerto Rico’s long-term financial plan, annual budgets, and effort to publish accurate and timely financial information. But he warned that “if the forthcoming bill seeks to extinguish rather than enhance” Puerto Rico’s democracy at the local level, he “will do everything in [his] power to defeat it.”

The question of extending Chapter 9 protections to the commonwealth’s public authorities has even less of a consensus. The argument against a Chapter 9 bankruptcy solution is that it would not force the commonwealth to take steps toward reforming its operating, accounting, and other financial reporting systems. Those who hold this view (such as we do) think that Puerto Rico should be allowed to restructure its debt only after it agrees to real lasting reforms of these practices and the assent of the majority of bondholders supporting the restructuring proposal.

In the meantime, PR House Bill 2786 would create a new, independent corporation whose only task would be to serve as a vehicle for PRASA to achieve financing at reasonable terms. It is based on the legislation that would provide for the restructuring of the Puerto Rico Electric Power Authority (PREPA), as agreed with a majority of its creditors. One difference is based in the fact that “PRASA has already a gross pledge whereby revenues go directly to the trustee, who pays first [PRASA] bondholders and then what is left is given to the utility. In this sense, PRASA does not have the same leverage to bring its bondholders to the table with the argument, ‘I won’t pay you.’” The head of PRASA has asserted that [PRASA has] repayment capacity for about $700 million, at a 10% [interest rate], but there is no access.”

Of continuing concern is the sentiment expressed against rate hikes. PRASA head Lázaro said that in the event of a rate hike, he explained the size would depend on the sacrifices the utility is willing to make when discussing the issue, but that it could be as much as $10 monthly. Lazaro said “I’m the last person who wants to increase the water rate. With House Bill 2786, “we are seeking to give certainty, mitigate the [financing] transaction’s risk and avoid a rate hike,” said Rep. Rafael Hernández, co-author of the measure and chair of the House Treasury Committee.

PRASA’s last water-rate hike back in 2013 was projected to cover all operational costs from its revenue, debt service until fiscal year 2018, and projected deficits during fiscal 2016 and 2017. But it also intended to pay for its capital improvement projects with external financing, and not with the utility’s revenues. What’s more, to pay roughly $90 million in short-term debt maturing on Feb. 29, PRASA would siphon its Rate Stabilization Fund — monies that were supposed to be used to cover projected deficits during fiscal 2016 and 2017.


The Chicago Public Schools yielded to investor uncertainty when it delayed its planned $875 million general obligation bond sale by moving it to the day-to-day calendar. The district’s finance officials said the decision was made to give investors more time to digest the deal and the underwriting syndicate time to make final structure revisions. The action followed  the General Assembly’s GOP minority leadership announcement of legislation backed by Gov. Bruce Rauner to put the district under state oversight and put it on a possible path to bankruptcy. The Board has obtained an opinion that its pledged revenues securing the planned bonds are special revenues for purposes of bankruptcy. We see that as being less than definitive.

The less than helpful comments from Springfield led to a pre-marketing wire offering spreads of more than 500 basis points to the Municipal Market Data’s top-rated benchmark. The 25-year and final 28-year maturities were offering a preliminary yield of 7.75%, 506 basis points and 502 basis points, respectively, over MMD’s AAA. Both were more than 400 basis points over a triple-B credit. The preliminary price on the taxable, 17-year maturity offered a yield of 9.75% with a coupon of 9.50%.

Chicago’s chief financial officer, Carole Brown, and CPS finance chief Ronald DeNard said that it had sufficient order interest to place with buyers at pre-marketing pricing levels distributed Tuesday. CPS bonds had been trading at a 350 to 375 basis point spread before the announcement. The district’s $300 million sale last spring saw a top yield of 5.63% on a 25-year maturity that was 285 basis points over top-rated MMD.


Two years ago, the use of Capital Appreciation Bonds by school districts in California for new construction led State lawmakers to pass AB 182 at the urging of then-State Treasurer Bill Lockyer after it came to light that many school districts had issued non-callable capital appreciation bonds with 40-year maturities and nominal interest-to-principal repayment ratios of 10-to-1 or even 20-to-1. The public relations poster child for the controversy was Poway Unified School District’s $105 million series, issued without a call option and requiring $1 billion of debt service through its 40-year maturity.

Initially the legislation and public uproar caused school CAB issuance to drop to $292 million of CABs in 2014. Once the concern died down, issuance of capital appreciation bonds by California school and community college districts more than tripled from 2014 to 2015. It was the highest level of school CAB issuance since 2009, according to CDIAC data. K-12 school districts conducted 46 CAB sales in 2015 totaling $691 million, compared to $250 million the prior year. The state’s community colleges executed eight CAB sales last year totaling $307 million, up from $42 million in 2014.

The legislation sought to limit CAB issuance by K-12 and community college districts, by requiring ratios of total debt service to principal for each series not exceed 4-to-1, and that bond issues include a 10-year call option. Permitted maximum interest rates were cut to 8% from 12%. Now that the negative uproar has subsided, K-12 school districts conducted 46 CAB sales in 2015 totaling $691 million, compared to $250 million the prior year. The state’s community colleges executed eight CAB sales last year totaling $307 million, up from $42 million in 2014. The increase occurred in the face of comments from some financial advisors and district officials, who have said that districts have been steering away from the structure after the wave of criticism that resulted in AB 182’s passage.

Disclaimer:  The opinions and statements expressed in this column are solely those of the author, who is solely responsible for the accuracy and completeness of this column.  The opinions and statements expressed on this website are for informational purposes only, and are not intended to provide investment advice or guidance in any way and do not represent a solicitation to buy, sell or hold any of the securities mentioned.  Opinions and statements expressed reflect only the view or judgment of the author(s) at the time of publication, and are subject to change without notice.  Information has been derived from sources deemed to be reliable, but the reliability of which is not guaranteed.  Readers are encouraged to obtain official statements and other disclosure documents on their own and/or to consult with their own investment professional and advisors prior to making any investment decisions.

Leave a Reply

Your email address will not be published. Required fields are marked *