Munis in Focus

Avoiding Puerto Rico: How Credit Research put us Ahead of the Crisis

David Hammer, Head of Municipal Bond Portfolio Management, explains the “red flags” that prompted PIMCO to sell out of Puerto Rico ahead of the crisis, and the factors needed to make the commonwealth an attractive investment in the future.

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Erin Leighty, Product Manager: Puerto Rico is top of mind for anyone investing in high-yield municipals. PIMCO was early to get out of Puerto Rico selling our last bond in early 2013. What drove this process?

David Hammer, Head, Municipal Bond Portfolio Management: So, I think that's a good example of our investment process in action, and that started in 2012 with the head of our municipal credit department raising some really significant concerns about Puerto Rico,

Map highlighting Puerto Rico and the United States.

and what we saw was the commonwealth that had been in a recession already for a number of years was beginning to decouple from the U.S. So, as the U.S. did better, the commonwealth didn't,

Shots from around cities in Puerto Rico.

and what we saw was a debt burden inclusive of pensions that totaled about $110 billion. So, not just the $70 billion in debt that is often quoted in the media, but also another $40-plus billion in unfunded pension liabilities. Given our view that GO bonds, when they compete with some of these essential services like pensions, have the potential to recover a bit lower than the market is traditionally expected. This raised a red flag.

Additionally, we also ran Puerto Rico with the assistance of our emerging markets team

Shots of PIMCO employees working.

through a model that they have to look at individual sovereign nations, and we thought this was important to take a step back and look at it not just as a municipal credit with the value of the tax exemption, but how the commonwealth would fair if it was truly standalone without the benefit of the U.S.

It scored very, very poorly. It supported our decision to de-risk Puerto Rico. We sold our last bond in early 2013. At the time it was AA rated, and once we concluded that we thought Puerto Rico would ultimately have to restructure all of their debt and liabilities,

Chart: The line graph shows the price of Puerto Rico general obligation bonds declining from March 2014 through March 2016.

we had some concerns over some specific liens that might look secured in a traditional muni bankruptcy, but because of Puerto Rico's unique status as a territory, might not be for Puerto Rico.

So, It was AA rated at the time we sold it. Today, that same bond is CC rated by two agencies.

Erin: Will you ever invest in Puerto Rico? What would you need to see to get back into the space?

David: Yeah. We get that question a lot, and we've been negative on Puerto Rico for so long, I think some investors wonder is there a time that we ever would and we would. I do think at some point there will be an opportunity to invest in Puerto Rico.

What we need are really two things.

So, first we need a haircut that right sizes not just debt, but all their liabilities including pensions versus the growth of their future economy. Because of Puerto Rico's unique status as a territory, they do not have access to Chapter 9. So, the U.S. bankruptcy code that we're accustomed to using when we invest, we're comfortable making decisions on bonds, that may go through Chapter 9, but we'll have a legal opinion what our claim is. It's really difficult to do that in Puerto Rico.

The conclusion really is if you're a bond holder and you think you have security, even though it says it in the prospectus, you might not actually have the security package you think you do once Congress gets involved. So, what we want is we want a haircut that's the right size versus the economy, and then secondly, we want a set of investable rules that we can depend on before we commit investor capital.

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