In a recent interview with Bloomberg, Jeffrey Gundlach made some surprising comments about Puerto Rico bonds:

He said investors with an appetite for risk should consider buying debt from Puerto Rico. Even though the securities will swing in price as the commonwealth and its agencies stagger under $73 billion of debt, Gundlach said they will find a way to pay.

“I don’t care if they flop around,” he said.

Like most people with a fixed income background, I have a lot of respect for Gundlach. I think his decision to start an infrastructure fund — which is discussed earlier in the article — will be both prescient and profitable. But I think he is way off on Puerto Rico.

(Besides, if Gundlach truly believes Puerto Rico is money-good, writing credit default swaps might be a better strategy. They are going for around 28–29% upfront and 500 bps a year. Since downward spirals usually last longer than most expect, it could be an interesting play. But I digress.)

In a sense, debating whether Puerto Rico will be able to service its debt going forward is purely academic. The territory is already borrowing funds to make its debt service payments — much of the bond proceeds from Puerto Rico’s general obligation bond offering last March were used for this purpose. So, technically speaking, the territory is not fully servicing its debt right now.

One of the risk factors that is cited in Puerto Rico’s offering documents is that the territory’s future required debt service payments escalate sharply from here. If Puerto Rico loses market access — which has already occurred with the investors who traditionally invest in tax-exempt debt — the government’s ability to kite payments is over.

Overborrowing as a pathology with a predictable course

In my mind, Puerto Rico is as obvious a candidate for sovereign default as they come. The territory is undergoing a species of debt crisis that has many historical precedents and a familiar trajectory. It is well understood that a borrower in Puerto Rico’s position is unlikely to recover economically while honoring its debts on time and in full.

Puerto Rico’s situation is accurately captured in Revisiting Sovereign Bankruptcy, Chapter 2: Pathologies in Sovereign Debt, incidentally co-authored by Lee Buchheit, whose firm is one of Puerto Rico’s advisors:

Overborrowing requires creditors in the private or official sector that agree to provide the needed financing. Overborrowing is often facilitated by herding behavior, which leads creditors to take on too much risk during periods of global optimism …

There is evidence that policymakers are often reluctant to restructure their debts and suboptimally postpone unavoidable defaults (e.g. Borensztein and Panizza 2009; Levy Yeyati and Panizza 2010; IMF 2013). Delayed defaults can lead to the destruction of value because a prolonged predefault crisis may reduce a country’s capacity and willingness to pay. Its capacity to pay is reduced because procrastination prolongs the climate of uncertainty, high interest rates and restrictive fiscal policies that are ineffective in avoiding default but amplify output contractions. Delayed defaults reduce its willingness to pay because electors that have suffered long periods of economic austerity are less likely to support a creditor-friendly debt restructuring.

Because policymakers are often replaced after a debt default, late restructurings may be caused by self-interested agents that have incentives to gamble for redemption, even when delays entail economic costs for society as a whole. Myopic policymakers who do not take into account the long-run costs of excessive debt accumulation may also decide to delay a default in order to have continuous access to external resources. Short political horizons may also create incentives to undertake policies that increase the vulnerability of the financial sector to government default. This generates short-term benefits in terms of a higher capacity to borrow, but at the expense of higher future default costs if the accumulated debt turns out to be unsustainable (Acharya and Rajan 2013).

This is exactly what is happening in Puerto Rico right now. Hedge funds and other institutional investors have stepped in as private lenders of last resort.

Although I would not say that we are experiencing a period of global optimism, the current interest rate environment is fostering the same herding behavior described above and is probably the only reason some otherwise sophisticated investors feel comfortable shrugging off the real risks involved in investing in Puerto Rico’s debt. And since this environment is the product of extraordinarily accommodative monetary policy, it will be similarly transitory.

So hedge funds will continue to stuff Puerto Rico like a giant debt piñata until a shift in capital flows busts it open.

There are at least two things that could cause Puerto Rico’s private lenders of last resort to vanish (and possibly abruptly). The first would be if interest rates stateside were to normalize. The second would be if any compelling distressed corporate opportunities presented themselves. As my friend @groditi has pointed out to me, one factor that has driven hedge funds to cross over to Puerto Rico’s debt is an overall lack of distressed situations in corporate debt.

Why monetary default has been characterized as inevitable for Puerto Rico

As far as I can tell, essentially three kinds of distressed investors are attracted to Puerto Rico’s paper:

(1) Investors who believe they can profit by purchasing the debt and then convincing traditional investors to return in the short or medium term;

(2) Investors who believe the government can successfully restructure the territory’s public corporations while protecting its general obligation, municipal, and COFINA debt; and

(3) Investors with unique theories about economic development and how Puerto Rico might go about broadening its tax base.

All of these scenarios strike me as unlikely.

Scenario (1)

In my opinion, traditional investors are unlikely to return to investing in Puerto Rico’s debt anytime soon. These investors never purchased Puerto Rico’s debt based on the territory’s credit fundamentals (although some with large exposures are now trying to suggest otherwise). They purchased the debt because Puerto Rico’s bonds are the only bonds in the market (of any real size) that are triple exempt.

Recent developments have since forced them to evaluate Puerto Rico’s creditworthiness. It is clear investors are not being compensated for the magnitude of financial risk and uncertainty involved or protracted headline risk (which is a big deal for some institutional investors).

It is also reasonable to fear that the federal government will rethink subsidizing Puerto Rico’s debt (through its tax exemption) given that Puerto Rico’s singular tax status has provided an obvious incentive for overborrowing.

Scenario (2)

Taken all together, Puerto Rico currently has around $71 billion of outstanding debt. Given a population of around 3.5 million people (roughly the same population as Connecticut), that amounts to around $20,000 of debt per capita and a debt-to-GDP ratio around 70%. Puerto Rico’s outstanding debt literally doubled from 2003 to 2012 as the territory borrowed to finance its deficits.

This debt burden is not even remotely comparable to any US state. According to Moody’s 2014 State Debt Medians report (subscription required), the median debt per capita for US states is $1,054. The median debt-to-GDP ratio is 2.4%. The only viable analogy here is with distressed sovereign borrowers like Greece.

Principal and interest payments consume about 15% of Puerto Rico’s budget and will swell by $287 million in FY 16 (which begins July 1, 2015). This burden will increase as Puerto Rico’s interest cost on future borrowings climbs. The general obligation bonds Puerto Rico issued last March have been hovering around 9.5% at a time when yields for other sovereign borrowers have been declining (and some have even turned negative).

The notion that Puerto Rico can successfully “ring-fence” its core obligations has been aggressively promoted by some market observers, who suggest that this approach could decrease Puerto Rico’s debt burden and improve liquidity for the Government Development Bank (GDB).

My first rejoinder to this is that it is impossible for any government to shirk financial relationships with entities that provide essential services. This is a fairly straightforward concept in credit analysis.

Furthermore, Puerto Rico has also shown zero ability to forecast its burn rate even two months in advance. Its liquidity position was off 17% from the predictions it made just in October. Its projections regarding the feasibility and financial impact of major restructurings are thus questionable.

When Puerto Rico went to market last March for $3.5 billion (which was the largest junk offering in the history of the muni market), officials told investors the offering would carry the territory for several years. Now they are back, one year later, with a $2.9 billion offering. It’s remarkable such claims have escaped the attention of regulators.

My second rejoinder is that, from a management standpoint, this effort seems futile. Let’s say, hypothetically, that the territory could restructure its public corporations as self-sustaining enterprises. According to recent disclosure documents, Puerto Rico’s total good faith and credit debt is around $18.6 billion and its total general fund-supported debt (which includes appropriation-supported debt and tax and revenue anticipation notes) is around $23 billion. For comparison, this is still around six times the median debt per capita for US states.

The government’s core debt obligations seem even less affordable when one takes into account that Puerto Rico’s pensions have a funded ratio of less than 9%, which means the government is close to having to cash flow benefits payments.

The structure of Puerto Rico’s required debt service payments also presents a major problem. Puerto Rico has ascending debt service payments but an economy that has been in decline since 2006, a rapidly shrinking labor force, and unemployment rate above 13%. Its debt burden and the tax base that supports that debt burden are moving in opposite directions.

These problems have been apparent to most analysts for a long time. Back in October, Moody’s published a report noting that “Puerto Rico’s [Sovereign Expected Default Frequency] measure indicates the highest sovereign probability of default globally.” (Moody’s Analytics, October 6, 2014)

Scenario (3)

Some investors believe the government could still identify new sources of revenue — a value-added tax, etc. These proposals strike me as increasingly unfeasible politically. Puerto Rico’s debt burden is so large that all of the revenue generated would have to be devoted to debt service. Puerto Rico’s maximum annual debt service for FY 16 is $1.16 billion and $1.18 billion if one also takes into account guaranteed debt.

Residents are already choosing to vote with their feet and seek new opportunities in the mainland US. It is difficult to imagine there is broad consensus among residents that they should stick around just to offer up the fruits of their labors to hedge fund investors. But this is precisely what investors who are arguing that Puerto Rico is money-good assume.

The government’s willingness to pay appears to be incrementally shifting in response to political pressure.

The role of bond insurers

One aspect of Puerto Rico’s future borrowing activity that intrigues me is the role of bond insurers. I have already written about their underwriting standards here.

A handful of bond insurers have significant exposure to Puerto Rico. From the Wall Street Journal:

MBIA, through its National Public Finance Guarantee Corp. subsidiary, insures $4.8 billion of Puerto Rico bonds, Assured Guaranty backs $5.4 billion through three separate subsidiaries and Radian Group insures $452 million through Radian Asset Assurance, according to Moody’s.

MBIA’s National Public Finance and Assured Guaranty Re Ltd., one of the three Assured subsidiaries, have the highest exposure to Puerto Rico bonds as a percentage of their “qualified statutory capital,” or assets available to cover unexpected losses, according to the Moody’s analysis. National Public Finance insures $4.8 billion but has only set aside $3.3 billion for unexpected losses, a ratio of 145%. Assured Guaranty Re backs $1.5 billion but has only set aside $1 billion, a ratio of 147%.

(NB: These figures are a bit dated as the article was written in the middle of last year. But the point still holds.)

Some have suggested that the bond insurers may continue to have a role in Puerto Rico’s future financings to reduce the risk of default. It strikes me that this has an interesting precedent in Harrisburg, Pennsylvania.

FSA continued to insure Harrisburg’s incinerator borrowings long after it became evident that the city was not actually financing project improvements and the city’s offerings were essentially robbing Peter to pay Paul. Why did the insurer do this? Because the moment Harrisburg lost market access — which would have been immediate absent credit enhancement — the city would default and the bond insurer would have to begin making payments. In this sense, the insurer had backstopped so much of the city’s debt that the insurer’s financial fate became intertwined with the city’s. This is what enabled a city with fewer than 50,000 residents (and scant taxable property due to its being the seat of government operations) to rack up hundreds of millions of dollars of debt, which eventually rendered the city insolvent.

(Puerto Rico is not eligible to file for Chapter 9 bankruptcy. But if it were, the territory would already meet the criterion for insolvency.)

So it is possible for a lot of sophisticated players to end up unfavorably involved in Puerto Rico’s debt crisis.

As a closing note, I anticipate many readers will react to this with “investors and the bond insurers are all just betting on a federal bailout.” The federal government engineered a quiet bailout years ago. While considerable, it is not sufficient to alter the territory’s financial predicament.

It strikes me as unlikely that Puerto Rico will receive much more, difficult as it is to handicap policymakers. First, bailouts have become politically toxic. Second, if the federal government planned to rescue Puerto Rico from its creditors, that probably would have happened billions of dollars ago.