On Tuesday, Puerto Rico increased the size of its general-obligation municipal bond sale to $1.7 billion from $1.4 billion, demonstrating the voracious appetite that tax-exempt investors have for higher-yielding bonds. Unlike the debt of the 50 states, Puerto Rico’s municipal bonds are tax exempt for investors all over the U.S. This makes the debt especially attractive to wealthy investors in states with high personal income tax rates (think New York). But you have to wonder how many of these investors took the time to read the offering statement of the deal and run some numbers.
If they had done the math, they likely would not be buying maturities that come due too far into the future, because it’s unlikely that Puerto Rico will be solvent enough to repay them.
Puerto Rico is a Caribbean island with a simple, local economy that was supercharged by tax breaks the U.S. Congress granted it to promote manufacturing. The Center for the New Economydescribed Puerto Rico’s economy with a few quotes from Richard Weisskoff’s book Factories and Food Stamps: The Puerto Rico Model of Development:
Puerto Rico was “the prototypical industrial colony, the archetypal case of the highest stage of development toward which many other Third World economies are moving. Its economy is open and dependent: open to both imports and exports; dependent on flows of foreign capital, government aid, and on the intangible methods, such as technology, consumption styles, and even wage levels for certain occupations.”
In that kind of an economy, both production and consumption are dominated by the foreign sector. The production of goods for export is dependent on “imported capital, imported investment, imported raw materials, imported technology, and imported spare parts.” Thus, most of the income derived from the manufacturing and sale of exports accrues to and is repatriated by absentee owners, with little impact on the local economy.
Puerto Rico could be described as America’s own Third World country. It has a per capita income of $15,203 — that’s less than half the level of the poorest state, Mississippi, where it’s $31,046 — and the official unemployment rate is 15.5 percent. Forty-five percent of Puerto Ricans live below the poverty line, and 20 percent of personal income in the commonwealth comes from federal or Puerto Rican public funds. In short, it’s an economy going nowhere.
But it’s Puerto Rico’s massive debt load that makes it resemble another crisis-stricken country that’s been in the news lately: Greece. Although the commonwealth’s debt load is only 89 percent of its GDP, Puerto Rico’s underlying finances are weakening, and a big reason why it has balanced its budget so far is because it sold tax anticipation bonds and transferred the funds into the general fund. In 2011 public revenues were $8.17 billion while expenditures were $9.07 billion. This shortfall was plugged with official funds from the COFINA Stabilization Fund, a government subsidiary that sold bonds to be paid off with future sales tax revenues.
The other way that Puerto Rico has been seeking to close its deficit is by selling public assets to private investors. In September 2011, Goldman Sachs and Albertis paid the government $1.14 billion to lease two toll roads for a 40-year concession. In August 2011, Puerto Rico got bids from 12 international consortiums for the island’s main transport hub, the Luiz Munoz Marin International Airport. There are plans afoot to privatize other public assets, including energy, public-school infrastructure, transportation and water assets. But these hard asset sales will only provide a one-shot infusion of cash to fill a budget hole. There is only so much family silver to sell.
Rating agencies placed Puerto Rico in the lowest tier of investment grade ratings: Moody’s rated it Baa1 with a negative outlook, S&P rated it BBB and Fitch rated it at BBB+. It’s not a giant concern to sophisticated investors if the rating slips into the junk category, but Puerto Rico’s borrowing costs will shoot up if that happens. Then the more dire question arises of what the government will do once it runs out of funds to cover pensions, social welfare funds, government payroll and debt service. As happened with Greece, bond investors continue to buy the debt assuming at some point the government will be bailed out by somebody, somewhere. Good bond investors know how to do financial calculations better than anyone. The Wall Street Journal quoted one skeptical investor:
Some investors remained undecided early Tuesday afternoon.
“There are those people who won’t touch [Puerto Rican debt] with a 10-foot pole, and those people who embrace it thinking, ‘Hey, it’s a commonwealth, the U.S. government won’t let it go under,’” said Steven Schrager, director of research at SMC Fixed Income Management, which oversees $150 million worth of munis in separately managed accounts. “Well, I don’t know about that, and I don’t ever want to find out.”
Caution, bond investors: There is no European Union standing ready to bail out Puerto Rico. If the U.S. Congress or Federal Reserve bailed out Puerto Rico, then they would have to bail out Illinois and California. And that is not going to happen.