Puerto Ricos $3.5 Billion GO Deal: Cure or Symptom?

Market Commentary
March 2014

Puerto Ricos bonds appear to be benetting from a rally in prices on the heels of its $3.5 billion general obligation bond offering last week. Some investors undoubtedly see the successful deal and subsequent relief rally as a sign that Puerto Rico has turned a corner. While the deal provides Puerto Rico with approximately one year of liquidity, it does so while further burdening an already heavily leveraged and scally stressed issuer with additional debt. In short, Puerto Ricos recent deal traded short-term relief from a liquidity crisis for elevated risk to the Commonwealths long-term solvency. Put another way, Nuveen Asset Management sees the deal as a symptom of Puerto Ricos economic and financial ills rather than a cure for those problems. As such, we do not expect Puerto Ricos bond rally to be durable. We believe continued economic weakening, escalating debt service obligations and the Commonwealths long-standing inability to deliver a balanced budget will almost certainly yield another liquidity crisis in fairly short order. This paper examines features of the recent deal we find instructive, the challenges we see to Puerto Ricos long-term solvency and a few common misconceptions and misstatements made about the security features backing the Commonwealths general obligation (GO) debt. Shawn P. OLeary
Vice President, Senior Research Analyst Manager Nuveen Asset Management, LLC

Use of Capitalized Interest Means the Fiscal 2015 Budget Wont be Structurally Balanced
Puerto Ricos bond offering generated $422.7 million of capitalized interest bond proceeds that are held to pay interest on a portion of the deal itself. Capitalized interest is rarely used on GO debt as typically the entity issuing the debt already has the resources available to begin comfortably paying debt service on the new bonds. Capitalized interest is usually reserved for revenue bonds, where a project that will later provide the source of debt service payment needs time to be constructed and become operational. According to our research, Puerto Rico intends to use the $422.7 million of capitalized interest to pay substantially all of the interest due on the bonds in Fiscal Years (FY) 2014 and 2015 (a portion of the FY2016 interest payments will also be made from capitalized interest). In FY2015 alone, Puerto Rico will utilize $269.8 million of capitalized interest to offset the cost of debt service on the new deal. A budget that relies on bond proceeds to partially pay for debt service as it comes due is, by definition, not a structurally

Molly Shellhorn
Vice President, Senior Research Analyst Nuveen Asset Management, LLC

NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE

Puerto Ricos $3.5 Billion GO Deal: Cure or Symptom?

March 2014

balanced budget. Structurally balanced budgets generally feature recurring revenue sufficient to meet recurring expenses. Therefore, by virtue of earmarking $269.8 million of bond proceeds for FY2015 debt service, Puerto Rico has already failed to deliver on its promise of a balanced budget in FY2015. A promise that, paradoxically, Puerto Rican officials were making while marketing the bonds to potential investors. This is very much in keeping with Puerto Ricos decade-long streak of promising to balance its budget, but ultimately falling short of that goal.

Debt Service Escalation Poses Continuing Risk to Puerto Ricos Solvency

Puerto Ricos recent bond deal placed substantial future burdens on an issuer already struggling to service the debt it issued prior to the new bonds. Setting aside the years in which capitalized interest is used for budget relief, the new deal increased the Commonwealths annual GO debt service payments anywhere from 31.8% to 125.6% for each year the new bond remains outstanding. Exhibit 1 compares Puerto Ricos annual GO debt service requirements before and after issuance of the recent deal. Though higher, starting in 2021 debt service levels off at roughly $1 billion, which is equivalent to approximately 10% of Fiscal Year 2014 General Fund revenues.

Exhibit 1: Puerto Ricos GO Debt Service Before and After March 2014 Deal
GO Debt Service Prior to Deal GO Debt Service Following Deal Debt Service ($000s)

$1,200,000 $800,000 $400,000 0

2015

2020

2025

2030

2035

2040

Source: Puerto Rico General Obligation Bonds of 2014, Series A Official Statement.

By comparison, Puerto Ricos COFINA (Puerto Rico Sales Tax Financing Corporation, or Corporacin del Fondo de Inters Apremiante) bonds feature a rapidly accelerating debt service schedule. While COFINA debt is not paid from Puerto Ricos General Fund, the bonds are paid from sales taxes that after COFINA debt service is paid flow to the Commonwealth for general expenses. Therefore, as COFINA debt service increases it consumes a larger portion of the revenues that otherwise would have flowed through to the Commonwealths General Fund. Exhibit 2 shows the escalation in COFINAs annual debt service.

Puerto Ricos $3.5 Billion GO Deal: Cure or Symptom?

March 2014

Exhibit 2: Puerto Ricos COFINA Debt Service Increases Steadily

$2,000,000
Debt Service ($000s)

$1,500,000 $1,000,000 $500,000 0 2015 2020 2025 2030 2035 2040 2045 2050 2055

Source: Puerto Rico Sales Tax Financing Corporation Basic Financial Statements and Independent Auditors Report FY 2012; Puerto Rico Sales Tax Financing Corporation Sales Tax Revenue Bonds, Senior Series 2011D, Official Statement dated 12/1/11.

COFINA debt service grows at a 4% compound annual growth rate from 2014 through 2041. While we believe debt service coverage for senior lien COFINA bonds should remain adequate through the life of the bonds, the steady growth in COFINA debt service will put significant pressure on the Commonwealths General Fund in the coming years. The Fiscal 2014 budget initially relied on post-COFINA sales tax collections for 9.1% of General Fund operating revenues. Taking into account the growth of COFINA debt service, increased cost of GO debt service and other Puerto Rico guaranteed obligations (i.e. appropriation debt and public building authority debt), debt service obligations paid either from the General Fund or from revenues that ultimately flow to the General Fund will grow by more than $720 million between the current fiscal year and Fiscal Year 2016. The increased debt service demands mean that, barring any other changes in Puerto Ricos revenues or expenses, the Commonwealth faces at least a $720 million budget deficit in Fiscal Year 2016. We also note that Fiscal Year 2016 will be the last full budget year for Governor Alejandro Garcia Padilla before he stands for reelection in the fall of 2016. We expect the kind of budget cutting and/or revenue generation needed to address this significant increase in debt service costs will be very politically difficult to achieve leading up to an election year. Moreover, Puerto Ricos Act 154 excise tax at present approximately 20% of Puerto Ricos General Fund revenue is set to be substantially modified and/or reduced in Fiscal Year 2018. At this point its unclear what the full magnitude of any modification and/or reduction will be, though we note this one tax represents a significant portion of Puerto Ricos revenues and is derived from a very limited of base of taxpayers. In short, we expect Puerto Rico will undoubtedly continue to wrestle with budget deficits and likely need to rely upon scoop-n-toss debt restructurings for the foreseeable future.

Puerto Ricos $3.5 Billion GO Deal: Cure or Symptom?

March 2014

Growing Economy Needed to Service Growth of Tax Supported Debt

When one looks at Puerto Ricos tax supported debt (general obligation, COFINA and guaranteed debt) in totality, its clear the debt was structured based upon an assumption of a steadily growing economy. Unfortunately for Puerto Rico, its economy continues to struggle with high unemployment, population loss and near steady decline in the Economic Activity Index (EAI). The EAI is a composite of four main economic indicators produced by Puerto Ricos Government Development Bank (GDB). Exhibit 3 shows the monthly year-over-year change in Puerto Ricos EAI.

to concerns regarding Puerto Ricos debt structure and economic trajectory. We observe many problems with this line of thinking, not the least of which are: Puerto Ricos constitutional and statutory protections for GO bonds merely establish budget priority, not a lien on specic revenues. GO pledges including the GO pledge offered by Puerto Rico merely promise an issuers good faith, credit and/or taxing power. There is no specific grant of a lien on collateral or other assets of the issuer. The promise offered by Puerto Rico amounts to a promise to budget GO debt service first when the budget is constructed and, should cash flow be insufficient to pay GO debt service when due, redirect revenues from other sources subject to their availability. This is very different from a true lien on revenues that mandates that bondholders are backed by a security interest in the pledged revenues. One need look no further than Puerto Ricos COFINA bonds that clearly state that COFINA bonds are payable solely from, and secured by a grant of a security interest in, pledged sales taxes. Puerto Ricos GO bonds, by comparison, are backed by the good faith, credit and taxing power of the Commonwealth. Note that there is no grant of a security interest in any specific revenue afforded to the GO bondholder. The use of a debt service coverage ratio to describe the security of Puerto Ricos GO pledge not only fundamentally misrepresents the nature of the pledge, it ignores how Puerto Rico actually regards its debt service obligations. Calculating debt service coverage for GO debt is inappropriate because it assumes all revenues are available and held for debt service, when in fact GO debt service is paid twice a year and other obligations are ongoing and continuous. Further, in order to accept the premise that Puerto Ricos GO bonds benefit from a specific lien on revenues that generate many multiples of coverage for debt service one must ignore the inconvenient fact that year after year Puerto Rico has relied on newly issued bonds to pay prior debt service. If, in fact, Puerto Rico paid GO debt service before all other obligations there would be no need to access the debt markets to ensure timely payment of principal and interest on GO bonds and other debts of the Commonwealth. Puerto Ricos long history of using new debt to pay prior debt reveals that the Commonwealth has never truly treated GO debt service as a first budget priority.

Exhibit 3: Puerto Ricos Economic Activity Index

Monthly Year-Over-Year Change
4% 2% 0% -2% -4% -6% -8% 2009 2010 2011 2012 2013

Puerto Ricos Economic Activity Index

Source: Economic Activity Index Puerto Rico Government Development Bank. Data from 1/1/09 to 12/31/13.

Puerto Rico has a long trend of economic difficulties and reports of population loss as Puerto Rican residents leave for the mainland United States in search of job opportunities. We expect it will take significant planning and time to implement the kind of sustained economic growth needed to promote fiscal stability and comfortably service Puerto Ricos tax supported debt, though we acknowledge the government has spent considerable time and effort outlining economic development strategies.

GO Pledge: Myths and Misconceptions

Some investors who are quite bullish on Puerto Ricos creditworthiness make assertions to safety regarding the Commonwealths GO bonds based upon specific protections provided by the Puerto Rican constitution and statutes. In some cases, these investors describe Puerto Ricos constitutional and statutory protections as constituting a lien on available revenues of the Commonwealth and quote specific coverage levels for GO debt service. These statements are often made in response

Puerto Ricos $3.5 Billion GO Deal: Cure or Symptom?

March 2014 As legislators our responsibility requires a broader vision.

As issuers become scally distressed, they may ignore promises of priority of GO debt over the health, safety and welfare of the issuers residents. As we have seen in Detroits bankruptcy case, when elected officials are forced to allocate scarce resources between bondholders and residents and/or employees, bondholders can be pushed aside if they do not have a perfected lien position or dedicated revenue pledge securing the debt. While Detroits bankruptcy case is still playing out, the city has filed a plan of adjustment that, in effect, largely treats GO bondholders as subordinate to retirees and citizens irrespective of the fact that Detroit claimed that its GO bonds were full faith and credit GOs of the city, payable from any funds available to the city for that purpose, as a first budget obligation. Quite simply, when it comes to GO debt, as an issuer enters into acute fiscal distress, elected officials may refuse to uphold a GO pledge, leaving GO bondholders with scant legal precedent to cling to for real security. We see no discernible difference between Puerto Ricos GO pledge and that of Detroit, who is trying to treat its GO bonds as completely unsecured obligations. While Puerto Rico and its corporations and instrumentalities are ineligible for Chapter 9 bankruptcy protection, they certainly can fail to make timely payment of debt service when distressed.

This responsibility is to the [Commonwealth] and not with a privileged group of lenders.

As mentioned above, when an issuer is in financial distress bondholders may be targeted before services to constituents and other favored groups. The sentiments above come from a small number of elected officials in opposition to a bond deal that provided Puerto Rico with a desperately needed window of liquidity that may well have staved off a potential default. Should Puerto Ricos fiscal and economic struggles continue and we believe they will it is likely that the sentiments above will become more widely held. We note that this is not a low probability or abstract risk. In the official statement for Puerto Ricos recent GO deal the Commonwealth disclosed 15 pages of risk factors related to their economic and fiscal challenges. Importantly, they noted that barring improvement in the economy and the governments finances Puerto Rico may need to institute certain emergency measures that could include the enactment of a statute providing for restructuring, moratorium and similar laws affecting creditors rights. This could affect the rights and remedies of the holders of GO bonds and notes of the Commonwealth and the enforceability of the Commonwealths obligation to make payments on such GO bonds and notes. Additionally, in a separate disclosure released at approximately the same time as bond offering documents, the Government Development Bank revealed they recently hired a noted restructuring firm as a consultant on the Commonwealths finances and capital structure. Finally, within days of the completion of Puerto Ricos recent bond sale, the presidents of Puerto Ricos Senate Finance Committee and Committee on Governance and Governmental Efficiency introduced legislation that would provide a mechanism for restructuring the operations and debt of certain Puerto Rican government instrumentalities and public corporations. Though the proposed bill contemplates creditors representing 75% of indebtedness would approve a debt modification plan, bondholders should be concerned. In the legislations present form, it is also unclear as to whether a court could simply ignore the will of 75% or more of creditors and impose a restructuring of debt. As of this writing the bill has yet to be called for a vote, but nonetheless marks a disturbing development for Puerto Rico bondholders.

Willingness to Pay in Doubt?

Puerto Ricos recent bond offering was very much a make-orbreak deal for the Commonwealth: it provided funding for payment of both short- and long-term obligations, termination payments to counterparties and a significant liquidity infusion for the Government Development Bank. Still, the bond authorization narrowly passed in both houses of the Puerto Rican Legislature, with a handful of senators in opposition to the bond deal making rather concerning statements regarding the Commonwealths ability to service all of its debt. In their Explanatory Vote Against the bill authorizing the bond offering, Senators Rosa Rodrguez, Nieves Prez and Fas Alzamora stated: It is time to recognize that our public debt cannot be paid in full. We cannot blow up our economy to satisfy financial institutions that have proven to be insatiable. Only economic growth will save us from this sad fiscal situation. Balancing the budget in a year will require an unacceptable sacrifice on our working and middle class.

Puerto Ricos $3.5 Billion GO Deal: Cure or Symptom? While the Commonwealths ability to pay its obligations has been very much in doubt for some time now, they are often credited with publicly stating their willingness to honor their obligations. Yet these recent developments should not be ignored and may portend a shift in their willingness to pay all of their obligations as they come due, particularly as their debt service obligations ramp up in the coming years.

March 2014

No Free Lunch
Puerto Rico bonds particularly bonds that lack a lien on specific revenues or are not backed by healthy bond insurers carry significant economic, fiscal and political risks. Investors should dispassionately review the legal protections afforded certain Puerto Rican bonds and carefully consider the likelihood the Puerto Rican economy can support the level of indebtedness required of the Commonwealth. We believe Puerto Rico has already fallen short of its promise to deliver a balanced Fiscal Year 2015 budget, will continue to see economic decline and by virtue of its recent bond deal has traded a year of improved liquidity for many years of increased risk of insolvency. Thus, the current rally in Puerto Rico bond prices appears to be largely unsupported by the trajectory of the credit and we expect the Commonwealth will once again face another liquidity crisis in the not too distant future.

For more information, please consult with your nancial advisor and visit nuveen.com.
SOURCES
Puerto Rico Government Development Bank Puerto Rico General Obligation Bonds of 2014, Series A Ofcial Statement, 3/14/14 Puerto Rico Sales Tax Financing Corporation Sales Tax Revenue Bonds, Senior Series 2011D Ofcial Statement, 12/1/11 Detroit General Obligation Bonds, Series 2008-A Ofcial Statement Senate of Puerto Rico, Explanatory Vote Against H.R. 1696, Senators Rosa Rodrguez, Nieves Prez and Fas Alzamora, February 27, 2014 Commonwealth of Puerto Rico Quarterly Report, 2/18/14 Government Development Bank for Puerto Rico Special Liquidity Update, 3/5/14 The Commonwealth of Puerto Rico Update on Fiscal and Economic Progress, Investor Webcast 2/18/14 and Investor Presentation Senate Bill 933, Public Corporation Restructuring Act, 3/13/14, Senators Rosa Rodrguez and Nadal Power Puerto Rico Sales Tax Financing Corporation Basic Financial Statements and Independent Auditors Report FY 2012 Puerto Ricos Management and Budget Ofce Organic Act Act No. 147 of June 18, 1980 as amended Bureau of Labor Statistics

RISKS AND OTHER IMPORTANT CONSIDERATIONS

This report is for informational and educational purposes only and is not intended to be relied upon as investment advice or recommendations, does not constitute a solicitation to buy or sell securities and should not be considered specic legal, investment or tax advice or analysis. The analysis contained herein is based on the data available at the time of publication and the opinions of Nuveen Asset Management Research. Information is current or relevant as of the date indicated and such information may become outdated or otherwise superseded at any time without notice. Certain information contained in this report is based upon third party sources, which we believe to be reliable, but are not guaranteed for accuracy or completeness. This analysis is based on numerous assumptions. Different assumptions could result in materially different outcomes. Past performance is no guarantee of future results. The report should not be regarded by the recipients as a substitute for the exercise of their own judgment. All investments carry a certain degree of risk, including possible loss of principal, and there is no assurance that an investment will provide positive performance over any period of time. Bonds and other xed-income investments are subject to various risks including, but not limited to interest rate risk or the risk that interest rates will rise, causing bond prices to fall; and credit risk, which is the risk that an issuer will be unable to make interest and principal payments when due.

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