Debt has been a hot topic worldwide the last couple of years as we see European nations as well as American cities struggle to get their hands around their funding needs. For the most part, those cities and states have been in the restructuring phase and we will continue to see these issues worked out over the coming years. Our Philosophy for Muni’s is similar to credit – find well-run municipalities in well-run states that are in a position to pay back their debtors. Not the time to reach for yield. History tells us that quality is the best option.
During our client event in January of 2014, I said “Puerto Rico has been in the news lately and will undoubtedly have to restructure or default on their debt. We have been following this development and anticipated additional risk for a while now and recently decided to reduce our exposure to this debt by selling out of one fund that had exposure to Puerto Rico to one that didn’t. It worked out well for us as the pricing continues to fall and we will continue to research and monitor other issues as they arise.”
In our opinion, to not see this coming, to get out or attempt to buy Puerto Rico debt “on the cheap,” was a drastic mistake. You have to question the intent or market knowledge of buyers of this debt after the numerous warnings that were issued. Many hung on to the General Obligation of the territory that made it illegal for Puerto Rico to go into default. However, as we’ve seen with the GM default in 2009 and the recent Detroit bankruptcy, the rules can easily be changed by the lawmakers if they deem it necessary. With $74 billion of debt outstanding and $49 billion in pension liabilities, the haircut to debt holders will be extremely large.
If you didn’t invest in Puerto Rico or Detroit, that is great, but if you did, you can use this as another learning experience. When something looks too good to be true, it probably is. The bonds were trading at over 500 basis points higher than a comparable credit and 200 basis points above junk even though it was still rated investment grade. Yet, many still were attracted to the yields because of the lower yielding alternatives.
Similar to the credit market, the tax free market has had a bull run of sorts as well. High quality municipals have performed well in years past with 2013 being described as bumpy. Many high profile cities and states have run into funding problems, including Detroit Michigan, California, Illinois, Connecticut, New Jersey, Massachusetts, Pennsylvania and Puerto Rico. The filing for bankruptcy by Detroit and Puerto Rico has served as a wakeup call to other cities in similar situations. Pricing on many muni’s has been sporadic as investors try to digest which issues are more financial secure than others.
It will be important to see how Detroit and Puerto Rico pan out in the end; not because we view this as an opportunity to invest but an opportunity to divest in some of the other funds that may be heavily invested in some of the less attractive states.
As of June 11, 2017, Puerto Rico voted over the weekend to join the US as the 51st state after voting down the measure four times before. Ultimately it is up to Congress to decide but at least it is a possibility. At this point, Puerto Rico knows the jig is up and is looking for any way out.