Some professional money managers do not know what a debt service reserve fund is
As has been expected for weeks now, Puerto Rico’s defaults continued and expanded today. Apparently the fact that that the general obligation bonds were paid this time around caught some investors by surprise, because those bonds inexplicably rallied. Seriously, the Puerto Rican government released a list of the bonds it would pay and not pay some time ago.
The Puerto Rican government has also explained how it was possible to pay the bonds that it did pay, as a means of making clear that these were some of the last payments it would be making on the debt. The government has been “clawing back” revenues from other bondholders to pay the debt service on the general obligation bonds. The government also tapped nearly $383 million of debt service reserve funds to make the payments it did, out of approximately $1 billion due. This means the commonwealth was short almost half of what it needed to make its required payments once other issue components were netted out and the amount it did default on is taken into account.
What is a debt service reserve fund? A debt service reserve fund is a fund that is established in order to make a debt service payment in the event that pledged revenues are insufficient to do so. For most revenue bonds, the debt service reserve fund is capitalized at the time the bonds are issued with bond proceeds — that is to say, with investors’ own money. Reserve funds may also be capitalized as pledged revenues accumulate or through a guaranty arrangement. There are also some types of funds that only come into play with a technical default. No matter how you cut it, however, reserve funds are non-recurring resources for the payment of debt. Once they are extinguished, there is a bona fide reckoning to be had.
The use of these funds also often gives bondholders rights to interfere in the operations of the entity that issued the debt, depending on how a bond contract or insurance policy is drafted.
So the fact that Puerto Rico made a large portion of its required payment through the use of reserve funds is not a benign observation. It means that the commonwealth does not have sufficient funds to service its debt and is now exhausting its absolute last resorts. This is the normal course of events on the way to monetary default, as many other distressed borrowers have demonstrated for as long as such rudimentary bondholder protections have existed.
So what do we read in the news about Puerto Rico’s defaults? From Bloomberg:
“In reality, this is a remarkably mild default, given the commonwealth’s repeated claims about its inability to pay debt,” said Daniel Hanson, an analyst at Height Securities, a Washington-based broker dealer. ”When a debtor repeatedly claims they have no cash but then pay more than $900 million in debt service, the credibility of the debtor must be called into question.”
Again, for competent bond investors, “cash” is not fungible. It matters what the source is.
“Puerto Rico opted for a default that would send a message about the need for Chapter 9 and the potential for a humanitarian crisis on the island without triggering a wave of litigation,” Mark Palmer, a managing director at BTIG LLC who analyzes Puerto Rico and municipal bond insurers, wrote Monday in a report. He said he expects insurers’ losses on commonwealth debt will be less than some predictions.
Yep, these will be the first defaults in the history of the bond market that do not trigger litigation. Incidentally, if Mr. Palmer had read Bloomberg days before, he’d know that Ambac and FGIC are already preparing lawsuits. Some analysis of municipal bond insurers.
Also, lawsuits often begin with technical defaults, not monetary defaults. Covenants are not included in bond contracts for the purpose of decoration. If you are a general obligation bondholder dependent on clawbacks for your payment — which many analysts already agree will be insufficient to begin with — this is a major problem for you. There is a nonzero chance a court will order the suspension of clawbacks while the practice is being contested because permitting them to continue involves obvious damage to interested parties.
John Miller, co-head of fixed income at Nuveen Asset Management LLC, which manages about $100 billion of municipal bonds, said Puerto Rico’s payment strategy was “the least disruptive to the marketplace” and “an effort to demonstrate their commitment to bondholder negotiations” while the island seeks debt relief from Congress.
“The ability of Puerto Rico to keep making all but a few smaller payments may actually add to the skepticism there, and cause U.S. politicians to push for the release of current financials and the imposition of a control board,” he said.
Puerto Rico’s governor did not even have the option of using that $383 million for any other purpose than paying bondholders this single time. Those funds sit with the bonds’ trustee, who serves as a fiduciary for bondholders. Never in a million years would I have imagined seeing professionals misrepresent the most basic of situations to this degree.
For some sanity, I recommend this observation from Municipal Market Analytics (subscription):
As they did in Detroit, solutions in Puerto Rico will almost surely depend on political considerations; the withering tone with which bondholders are being discussed will only diminish future recoveries. And, finally, today’s rally in PR GO bonds is yet another exit door for par-oriented investors. Defaults in non-GO securities imply nothing else but a gaping budget crisis, a systemic breakdown in both willingness and ability to pay, and thus a rapidly rising likelihood of GO defaults.
We get another shot at this drama in July, when over $800 million in GO debt service must be paid.
I have explained here, here, here, here, and here why this situation will only get worse. Be careful who you listen to about Puerto Rico. It would seem there is no shortage of market professionals who flunked Credit 101.