Analysis & Opinion

For Puerto Rico, Winter Is Coming

As liquidity crisis deepens, restructuring of 'debt complex' likely

by Triet Nguyen

Mr. Nguyen is managing director of New Oak Capital
NewOak is an independent financial services advisory firm. Led by a team of experienced market and legal practitioners, NewOak provides a broad range of services across multiple asset classes, complex securities and structured products for banks, insurers, asset managers, law firms and regulators, including financial advisory and dispute resolution, valuation, credit and compliance, risk management, stress testing, model validation and financial technology solutions. Reprinted with permission.


June 22, 2015—In the hit TV series, “Game of Thrones”, lead characters from the so-called House Stark are known to mutter under their breath that “Winter is coming”, an ominous foreshadowing of darker days to come.

As the liquidity crisis in Puerto Rico (PR) deepens and a broad-based restructuring of the entire PR debt complex looks increasingly likely, participants in this high-stakes fiscal drama may well wonder if “winter” has not already arrived.

Although no stranger to volatility, PR investors have found themselves whipsawed between extremes of panic and relief over the past couple of months. The market’s disappointment was certainly palpable after the Padilla Administration’s tax reform efforts were defeated on April 29, with the help of some of the governor’s own party members.

The benchmark PR GO 8.00% of ’35 plunged to a new dollar price low of 77 1/8 to yield 10.81% by the end of April, with most of the size trade volume clustered around the 80 level. The clearest sign of market capitulation, however, was the selling pressure experienced by the Cofina complex.

Up until now, the Cofina bonds, particularly the senior lien series, have been in relatively stable hands. There was a belief, which we also subscribed to, that Cofina bonds benefit from the best security structure within the PR debt complex, although we fear such security may have now been compromised by the Padilla team’s efforts to substitute a value-added tax (VAT) for the originally-pledged sales & use tax (SUT).

Throwing in the towel

With the demise of tax reform efforts and the uncertain outlook for completion of the $2.9 billion PRIFA issue, many Cofina bondholders have apparently thrown in the towel. All Cofina series have traded down to the low 60s in dollar price, regardless of lien status.

Never mind that, by our own calculations, current debt service coverage on the senior bonds stands in excess of 7.00x, based only on the original 6% rate, and on a first dollar collected basis, no less. With its back against the wall, La Fortaleza shifted gears and pushed through a large increase in the current sales and use tax as an interim measure, with the intent of transitioning to a full VAT structure down the line.

This last ditch effort did pass, allowing the market to breathe a sigh of relief, and for the PR GOs 8.00% of ’35 to rally to as high as 84 (for trades of over $1 million). That price rebound has turned out to be short-lived and we suspect many key players took advantage of the opportunity to reduce their holdings.

As the initial euphoria faded, it didn’t take long for the PR 8.0% of ’35 to return to around 80, with the yield back well above 10%. Unfortunately, the latest liquidity report from the Government Development Bank of Puerto Rico (GDB) will only add to investor anxiety. As of May 31, the bank reported net liquidity of $778 million, down a stunning 24% from $1.02 billion at the end of April.  Cash and bank deposits plunged 62% to a mere $72 million.

Some of this decline in liquidity may be attributable to the continuing shortfall in tax collections, to the tune of about 4% for the fiscal year-to-date as of May. Signs of a liquidity crunch can be found everywhere. The governor has filed a bill to allow (read: force) its public entities to purchase some of the GDB’s Tax and Revenue Anticipation Notes (TRANs).

Among the targeted entities: the State Insurance Fund, the Administration for Compensating for Automobile Accidents, and the Insurance Fund for Temporary Non-occupational Incapacity. The GDB has also approached holders of its $3.9 billion notes with an offer to extend maturities in exchange for higher interest rates.

The bank is literally scraping the bottom of the barrel, looking for any nickel and dime it can find. While Rome is burning, what has the PR legislature been doing? Instead of passing the long-term balanced budget plan that they’ve been told is critical to regaining some degree of market access, they’ve spent the last few weeks debating how to grant immunity from lawsuits to the board members of the GDB.

Checking their legal liability

Just the fact that they are concerned about their personal legal liabilities at this juncture may be viewed as a bad sign unto itself. Most disturbing, however, is the fact that the Padilla administration appears to be backing off from its previous stance on protecting the GO and related debt.

Last week, local news sources on the island reported that the Padilla administration considered asking Congress to expand HR 870 to include all Puerto Rico debt—not just the public corporation debt—but has now abandoned that thought process. We suspect the very idea did not get a very warm reception from members of Congress, since even U.S. states don’t have access to Chapter 9 at this time.

The bank is literally scraping the bottom of the barrel, looking for any nickel and dime it can find. While Rome is burning, what has the PR legislature been doing?

Just the mere fact that the governor was willing to go there after all the talk about ring-fencing the GOs should make investors very, very nervous. And then you have Senate Bill 1434, which, among other things, would amend current law to allow the Commonwealth to suspend required monthly GO bond fund deposits during fiscal year 2016 if it fails to raise $1.2 billion in TRANs.

As you know, since GO debt issues are usually not secured by a debt service reserve fund, the monthly deposit requirement is meant to be an early warning system to alert bondholders of any potential problem before the next semi-annual interest and principal payment is actually due. A violation of such a deposit requirement without bondholder approval would almost certainly constitute an event of “technical default” under the respective bond indenture.

But then again, the PR government has shown itself all too willing to change the rules of the game to suit its purpose. The bottom line: Governor Padilla is now willing to put the “constitutionally protected” GO debt in play. Yet is a “holistic” debt restructuring even possible for PR, given the wide array of creditor groups with starkly different motivations?

Clipping the tax-exempt coupon

The mutual funds are hell-bent on clipping the tax-exempt coupon for as long as possible and may be willing to take some capital losses in the process.

The bond insurers feel they’re adequately capitalized as long as they only have to pay principal and interest when due and no actual haircut to principal is required. The hedge funds are focused primarily on capital appreciation, and the haircut they may accept will depend primarily on what their cost basis is.

That said, the hedge funds themselves have bifurcated into two distinct groups, with potentially conflicting investment objectives. On the one hand, you have the G.O. holders, who support the government’s attempts to restructure only the public service corporations, either through the now-invalidated Recovery Act or through current efforts to convince Congress to give PR access to Chapter 9 proceedings.

On the other hand, you have the PREPA players, who are intent on derailing any attempt to ring-fence the G.O.s and related credits. It is puzzling to us that very few hedge funds have taken a more holistic view of the PR debt situation, as it is quite obvious that all PR credits are inter-related and should be analyzed as a whole. In the midst of all this turmoil and uncertainty, it is certainly ironic that PREPA should stand out as the most “manageable” distressed situation on the island, if only in a relative sense.

After all, in contrast to the rest of the island’s debt issuers, PR’s electric service monopoly is actually a stand-alone enterprise with definable assets and cash flows that can be valued. And, for better or worse, its restructuring evaluation process, which started just about a year ago, is nearing a conclusion, whatever that may be.

By the end of this month, PREPA’s creditors will find out what Lisa Donahue has in mind for both the July 1 coupon payment as well as what kind of “shared burden” (read: principal haircut or debt moratorium) she will be proposing for the utility’s debt. Investors who don’t belong to the restricted creditor group may want look for a clue in the initial restructuring report presented to the bondholders on June 1.

Even though no specific details were disclosed in the version released to the public, the projected “shared burden” was estimated at 6.2 cents per kwh (page 26) over a total pro forma rate base of 29.2 cents. Assuming this so-called “burden” is allocated equitably among all PREPA stakeholders, one should be able to back into an estimate of the target haircut or debt moratorium (NewOak clients can use our fully unlocked PREPA recovery model for this purpose).

Bondholders will present a restructuring plan as well

Not to be outdone, the bondholders themselves are apparently poised to present a restructuring proposal of their own, the third such attempt since the expiration of the initial forbearance period.

Regardless of which proposal ultimately prevails, it’s fairly clear to us that PREPA will ultimately morph into a pure transmission and distribution system, with most, if not all, of its generation capacity privatized. Perhaps members of the PREPA board and management team have seen the writing on the wall and that is why so many have resigned over the weekend?

At this writing, there are reports that the PR House of Representatives is poised to pass a “balanced” budget for FY2016. While any positive budget development—well any positive development at all—would be helpful at this point, we will remain skeptical until the deed is actually done. Besides, a one-year balanced budget still falls well short of the long-term structural deficit solution the market is clamoring for.

We’ve said before that PR keeps lurching from one liquidity crisis to another. Every single time, the Commonwealth’s solution has been to keep borrowing. That window is now closing and the endgame, whatever it may turn out to be, is drawing near. Could winter finally be descending upon this beautiful, sunny island?