July 6, 2016
- Puerto Rico missed $911 million in bond payments on July 1, including $779 million in payments of general obligation debt.
- On June 30, President Obama signed legislation sheltering Puerto Rico from creditor litigation and allowing it to restructure its debt using U.S. courts in exchange for establishing a federally appointed control board with authority over the island’s fiscal policy.
- While certain hedge funds and mutual funds will be hurt by the restructuring, Puerto Rico’s default should have limited impact on capital markets in general, as investors have been aware of the territory’s debt problems for several years and bond prices already reflect the associated risk.
- Cost-cutting reforms enacted by the control board could negatively affect Puerto Rico’s commercial real estate markets as public-sector job cuts, emigration and declining household incomes reduce demand for office and retail space.
Debt Relief Legislation Approved
Puerto Rico defaulted on its debts for the fourth time on July 1, missing $911 million in debt payments including $779 million in general obligation bonds. This is the first time Puerto Rico has defaulted on its general obligation debt and the first time any state-level borrower has defaulted on such debt since Arkansas in 1933.
Anticipating the default, President Obama signed the Puerto Rico Oversight, Management and Economic Stability Act (PROMESA) into law on June 30. PROMESA grants Puerto Rico access to U.S. federal courts to reduce its obligations and puts creditor lawsuits on hold. In essence, the law permits the island to pay less than 100% of what is owed on its debts to ensure that all creditors get something and the island's economy can recover.
In return for access to the courts, PROMESA establishes a control board to manage the territory’s debt restructurings and approve its fiscal plans. The board, whose seven members will be appointed by the president from a candidate list supplied by Congress, is granted broad authority to implement reforms to bring Puerto Rico’s debt under control and repay creditors.
Critics of the legislation condemn the control board as undemocratic, as it is not accountable to the island’s government or its electorate. Supporters contend it is a necessary response to the island’s rapidly deteriorating financial situation that will provide greater clarity, reduce the likelihood of disruptive litigation, and enable the territory to eventually return to self-sufficiency with full access to bond markets.
A Difficult Position
Favorable tax treatment fueled investment in Puerto Rican municipal bonds, but has now resulted in an economy with unsustainable debt. Puerto Rico has racked up $70 billion of debt across more than a dozen issuers as it borrowed to paper over budget deficits.
Puerto Rico’s status as a U.S. territory has hindered its ability to deal with its debt crisis. Its residents are U.S. citizens and can move to the mainland without going through an official immigration process. Many have already done so to escape the island’s economic decline. According to the Wall Street Journal, Puerto Rico has lost almost 10% of its population over the past decade, and the shrinking tax base has made it increasingly difficult for the Puerto Rican government to remain solvent. As neither a state nor a sovereign nation, it could not, until the enactment of PROMESA, access U.S. bankruptcy courts, declare a legal default or seek emergency loans from the International Monetary Fund. In short, there was no legal mechanism through which Puerto Rico could discharge its debts.
Impact on Capital Markets
The default should have limited impact on the greater capital markets. The bond market has been aware of Puerto Rico’s problems for several years, so the latest defaults did not come as a shock. While there will be large losses for some funds and investors, there is little systemic risk. The greatest losses will be for investors who bought Puerto Rican bonds chasing yield. Hedge funds and mutual funds are among the large holders.
Impact on Commercial Real Estate
Regardless of the form restructuring takes, decreased government spending will continue for the foreseeable future as the control board tries to bring Puerto Rico’s overall debt-to-GNP ratio to a more sustainable level. In order to achieve this level of stability, public-sector job cuts may be necessary to bring down overall expenditures. Because public administration activities account for almost 25% of jobs in Puerto Rico, there could be a negative short-term impact on the local office market in the form of rising vacancies and suppressed rents.
The retail sector may also experience a short-term contraction, due to the loss of population and a decline in household income. Retail was already impacted by a 2015 increase in the Sales and Use Tax (SUT) from 7% to 11.5%, which was converted to a Value Added Tax (VAT) in April 2016. A dispute with the government over these tax increases by business services and retailers may cause more retail chains and local stores to close, and impede foreign brand growth in the short term. However, the pains associated with the restructuring could be short lived as these same foreign brands look for growth opportunities in under-valued markets.
Rating agencies Moody’s and S&P have officially declared Puerto Rico in default of its debt, according to its creditor agreements. This status will make it even harder for the impoverished U.S. territory to raise funds and keep its government running. The greatest risk for Puerto Rico is not just failing to fund its government, but longer term, the possibility that its defaults and subsequent restructuring of its debt may prompt creditors to shut the territory out of global capital markets.