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Puerto Rico-The Rich Port
Sunday 8, October 2017

YaniqueF

 

Puerto Rico-The Rich Port?

 

There are many who upon learning that Puerto Rico is Spanish for rich port and is also referred to as the island of enchantment would probably bite back a quick snicker.  This island is a territory of the United States and people born there are natural-born citizens of the U.S.  However, interestingly enough, they are unable to vote for either the U.S. President or Vice President because the island is not a U.S. state.  This means that the Puerto Rican citizens may move freely between their island and the U.S. mainland. Fortunately for them, Puerto Ricans are exempt from U.S. federal tax on Puerto Rican income.

All eyes have been on Puerto Rico in the aftermath of hurricane Maria.  While there are many places in need of assistance due to the numerous powerful hurricanes experienced this year, Puerto Rico is unique because it was already in deep trouble.  The island has been in a recession since 2006 but lured investors by offering high rates, however, by 2016, they stopped servicing their debt.  When President Trump refers to Wall Street and the debt, he is most likely referring to some of the hedge funds that invested in the bonds.  The figure is pretty intimidating as it is estimated at US$72 billion in bond debt, which does not take into account the US$49 billion in unfunded pensions. 

Let’s take a closer look at the debt.  Firstly, it was tax free, which in addition to the attractive rates made it irresistible to investors.  Secondly, until 2016, investors were not fearful because states and territories were not allowed to declared bankruptcy, so they figured that no matter how bad the fundamentals may have been, the U.S. would have bailed out the territory.  Unfortunately for the investors, the U.S. Congress set up a new law which under Title III were able to shield territories from creditors a.k.a. bankruptcy.

You may be asking what led to all of their problems.  The ability for citizens to move freely between the island and the mainland has led to mass migrations, people simply left for better opportunities.  Rating agencies have cited unrealistic budget and revenue estimates, and lack of fiscal discipline.  The unemployment rates are very high, and this is in addition to very low labour participation rates.  The island has high numbers of low skilled workers, while more educated workers migrate.  In fact, the unemployment rate is nearly 40 percent for people aged sixteen to twenty-four, many of whom get by using the island’s version of Food Stamps, remittances from relatives on the U.S. mainland, in addition to others applying for disability benefits.

One of the most damaging factors has been the high cost of doing business in Puerto Rico, leading to a severe lack of competitiveness.  This is partially due to restrictions on the minimum wage.  Even though the island’s economy is not on par with the U.S., they have a binding minimum wage, as the U.S. federal minimum wage applies even though the U.S. level is quite high relative to the wages the average worker could expect to earn on the Island.  This is even worse when wage levels are compared to worker productivity levels which are astonishingly low.  This would be a nightmare scenario for most businesses.

Puerto Rico worsened their debt situation by issuing two new types of bonds, these are Capital Appreciation Bonds (CABs) and COFINA bonds (Capital Appreciation sales tax bonds).  The CAB pays interest only when the bond is redeemed, compounding and accruing those payments with the principal at the time of redemption of the bond. In the case of Puerto Rico, the maturity is 55 years. The COFINA bonds are backed solely by sales tax revenue and have a minimal probability of redemption. The complex nature of Puerto Rico’s bonds, issued by 18 different debt issuing entities all with different legal protections and financial obligations, creates massive challenges in the municipal bond space – no U.S. state has ever restructured its general obligation debt before.  Please note that all these problems existed before Hurricane Maria, so I have spent no time telling you what the damage estimates are (95 billion) and the urgent liquidity crisis facing the island.  It is definitely a case of bad being made worse.  However, we will see how the current U.S. administration responds to the crisis, and how much debt forgiveness if any is granted, as well as the restructuring options granted to the island of enchantment.

 

Yanique Leiba-Ebanks, CFA, FRM is the AVP, Pensions & Portfolio Investments at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm Feedback:  If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm

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