The Cautionary Tale of Puerto Rico

Many investors have no doubt seen the recent headlines about Puerto Rico’s inability to repay its approximately $72 billion in debt. The situation is illustrative of how our investment approach works and is a cautionary tale for bond investors chasing yield and income.

What’s it all about?

Puerto Rico’s Governor Alejandro Garcia Padilla announced last Monday that the commonwealth’s debt is not sustainable. With Puerto Rico’s economy in recession since 2006, many Puerto Rican residents have been migrating to the mainland in search of jobs and opportunities. The result of a stagnating economy and population exodus is lower tax revenues that make it harder for the government to service payments on existing debt.

Puerto Rico’s $72 billion of government debt outstanding is the largest per-capita municipal bond burden of any U.S. state.1 Given its dire fiscal situation — which has been brewing for a few years now, with budget deficits accumulating year after year — the commonwealth’s obligations were downgraded to a junk rating by the major credit rating agencies last year. In light of the recent announcement, rating agencies have further downgraded the debt.

Unlike U.S. cities and municipalities, Puerto Rico, because of its commonwealth status, cannot declare bankruptcy; however, it is lobbying for a change in legislation to allow it. Without the option of bankruptcy, Puerto Rico must work with its many creditors to restructure the debt (a protracted process that many estimate could take years).
One of the proposals for restructuring is a debt exchange, whereby creditors could exchange existing debt for new debt with more favorable terms for Puerto Rico (i.e., longer payment schedules and lower interest rates).

The price of yield

Among the largest holders of Puerto Rico’s debt are bond mutual funds and hedge funds, which together hold approximately $26.3 billion of the $72 billion of debt outstanding.2 Puerto Rico’s municipal bonds seemingly had a lot to offer investors. In 2014, Puerto Rico issued general obligation bonds yielding 8.7%, at a time when 10-year U.S. Treasuries were yielding 2% – 3%.3 In addition to these attractive yields, Puerto Rico’s bonds have the added benefit of being exempt from both federal and state taxes (in all 50 states), a boon for municipal bond investors residing in high-tax states.

In this period of low interest rates, many retail bond mutual funds have extended their maturities and lowered the quality of the bonds held to increase the yield to attract investors. After the 2014 downgrade, Puerto Rico moved from representing 2.5% of the main Barclays municipal bond index to representing 21% of Barclays’ high-yield muni index.4

Fund managers typically don’t veer too far from the weightings of their benchmarks and may be holding Puerto Rico paper to match the yield and other characteristics of the index. It’s a lot easier to exclude Puerto Rico when it’s 2.5% of your benchmark than when it’s 21% (and even more today).

As a side note, the high-yield corporate bond market is much more diffuse and does not have the risk of any one issuer so dominating the index as Puerto Rico has in the high-yield municipal market.

As those muni bond fund prices decline on the recent news, investors are paying the price of reaching for yield at the expense of solid credit analysis. Yield isn’t a lot of help if your principal declines — which is why a focus on a total return approach, especially in an asset class like bonds, can provide stability in a portfolio.

The current situation in Puerto Rico reminds us again that risk and return are related. There is no free lunch in investing, and the higher yields that may have attracted investors also reflected the tenuous fiscal situation of the commonwealth.

 

Hewins Financial Advisors, LLC d/b/a Wipfli Hewins Investment Advisors, LLC (“Hewins”) is an investment advisor registered with the U.S. Securities and Exchange Commission (SEC) under the Investment Advisers Act of 1940. Hewins is a proud affiliate of Wipfli LLP. Information pertaining to Hewins’ advisory operations, services and fees is set forth in Hewins’ current Form ADV Part 2A brochure, copies of which are available upon request at no cost or at www.adviserinfo.sec.gov. The views expressed by the author are the author’s alone and do not necessarily represent the views of Hewins or its affiliates. The information contained in any third-party resource cited herein is not owned or controlled by Hewins, and Hewins does not guarantee the accuracy or reliability of any information that may be found in such resources. Links to any third-party resource are provided as a courtesy for reference only and are not intended to be, and do not act as, an endorsement by Hewins of the third party or any of its content or use of its content. The standard information provided in this blog is for general purposes only and should not be construed as, or used as a substitute for, financial, investment or other professional advice. If you have questions regarding your financial situation, you should consult your financial planner, investment advisor, attorney or other professional.
Rafia Hasan
Rafia Hasan

CFA, CFP® | Director of Investments

Rafia Hasan, CFA, CFP®, is the Director of Investments for Hewins Financial Advisors, based in Chicago, IL. Rafia is a member of Hewins' Investment Committee and has a deep knowledge of the financial markets, specifically in the areas of alternative investments and private equity. She also specializes in personal financial planning and estate planning for women investors.

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The Cautionary Tale of Puerto Rico

time to read: 3 min