Richards: PREPA bonds the best bet in Puerto Rico
The following feature originally appeared in the June 28, 2015 issue of the Wall Street Week Newsletter. Subscribe – it’s free.
A typical distressed debt investment might represent 1-2% of Marathon Asset Management’s portfolio, according to co-founder and CEO Bruce Richards. But when the $12.5 billion hedge fund really likes an idea, position size can grow to as much as 5%. Bonds in Puerto Rico, he said, fall into the really-like category thanks to their uniquely attractive value proposition in today’s yield-starved environment. Besides providing a valuable lesson in risk management, Richards’ thesis on Puerto Rico warrants closer inspection.
Puerto Rico bonds have long been enticing because of their triple tax-exempt status. All municipal bonds are exempt from federal taxes, but only muni bonds in an investor’s home state are also exempt from corresponding state and local taxes. Puerto Rico bonds, though, are automatically exempt from federal, state and local taxes no matter where the investor lives.
Because it is a municipality, Puerto Rico’s debt is secured not by hard collateral, as it would be for individuals or companies, but rather by its taxation power. Municipal defaults, as a result, are rare. However, skeptics believe the commonwealth and its state-owned power authority could be headed for default due to ongoing political turmoil and lackluster economic growth on the island.
The S&P downgraded Puerto Rico general obligation (G.O.) bonds in late April from B to CCC+ with a negative outlook, putting further pressure on the embattled government. The island’s debt load of nearly $80 billion has now been in distress for more than a year without meaningful restructuring and reform. However, a groundswell of support continues to build from hedge fund managers in desperate search of fixed income yield.
Among those betting on Puerto Rico are Paulson & Co., which has invested over $1 billion in real estate projects. York Capital Management, NRG Energy Inc. and ITC Holdings Corp. are discussing investing up to $3.5 billion in the commonwealth, much of it to modernize Puerto Rico’s energy infrastructure. DoubleLine Capital’s “bond king” Jeffrey Gundlach, the featured guest on Episode 1 of Wall Street Week, has also been outspokenly bullish on Puerto Rican debt.
Speaking at the Ira Sohn Investment Conference in May, Gundlach made Puerto Rico G.O. bonds his “best idea” due to the fact he believes many of its problems are already priced-in. DoubleLine’s Income Solutions Fund holds nearly $50 million in Puerto Rican debt maturing in 2035, which at the time of his presentation were trading at around 80 cents on the dollar and yielding close to 11%. Gundlach has stated intentions to increase the firm’s exposure to Puerto Rico in the case of further weakness, which he believes a likelihood.
While he likes Puerto Rico G.O. bonds, Richards is more excited about the opportunity in debt of the commonwealth’s state-owned power company, the Puerto Rico Electric Power Authority (PREPA). Essentially, Richards and other fund managers believe PREPA can avoid restructuring its $9 billion debt by accepting a $2 billion cash infusion from a group of financial institutions, an arrangement would allow creditors to avoid principal reductions on debt. He emphasizes that PREPA is a solid company and valuable asset that can be saved with long-term investment in modernizing facilities and increasing efficiency.
As is the case with many large-scale direct distressed debt investments, Marathon is not simply putting money in and crossing its fingers, the firm and its partners are taking a proactive approach in order to improve the deal’s likelihood of success.
“We look at Puerto Rico and we say there’s a better way to run the energy platform in Puerto Rico than what’s currently being run, so we’re trying to work with the authorities in Puerto Rico,” Richards said. “We have a plan to put $2 billion of new money in, along with GE, to build a power plant on the island. That’ll do three things. Number one, it’ll create jobs. Number two, it will bring down, we believe, the cost of energy, and supplying energy, and also allowing Puerto Rico to be energy self-sufficient.”
Gundlach’s expectations for even lower prices on Puerto Rican debt are being met this week as Puerto Rico’s junk-rated G.O. bonds hit a new record low ahead of a precarious bond payment for PREPA. The sell-off intensified Wednesday when the chairman of Puerto Rico’s Government Development Bank (GDB) resigned for “personal reasons.” Puerto Rican legislators also met with creditors in New York this week in an attempt to hash out restructuring of PREPA debt. The utility is an estimated $150 million short of reserves required to make a $416 million July 1 interest payment.
In testimony before the U.S. House of Representatives this week, Puerto Rico’s Attorney General Cesar Miranda Rodriguez said, “The fiscal and economic situation in Puerto Rico has reached a tipping point. The situation is truly dire.” Rodriguez is pushing the U.S. government to allow the commonwealth to be treated as a state under Chapter 9 bankruptcy code, which would allow public corporations (like PREPA) to go into bankruptcy, but such a scenario appears unlikely for now.
Posturing takes place in almost all debt negotiations (see Greece), but recent desperation from Puerto Rican officials highlights the volatility involved with distressed debt investments. The night is darkest before the dawn, and Gundlach believes that because much of the commonwealth’s pension obligations are held by the island’s residents, there are deep incentives to avoid a default that would wipe out much of the population’s savings pool.
Investors in Puerto Rican debt are displaying a voracious risk appetite, but believe the commonwealth’s distressed bonds represent a calculated risk worth taking, especially given the current dearth of compelling high-yield opportunities in global credit markets.