Investing in Puerto Rico: What Investors Should Know
In recent quarters, investors have been on high alert about Puerto Rico’s ailing financial situation.
The concern was sparked by the US territory’s ongoing recession, which has been characterized by high unemployment, $70 billion1 of total debt and a consecutive streak of annual budget deficits.2 Compounding investors’ fears were Detroit’s recent bankruptcy filing and June’s massive sell-off in the municipal bond market, which may have caused some weakness in Puerto Rico’s debt.
Certainly, investing in Puerto Rico can be risky. However, as active managers, we believe risks can be mitigated by thoroughly understanding each issue, and that even controversial regions may contain attractive relative value opportunities with income that we can pass on to our shareholders.
We cannot be certain what the situation in Puerto Rico will look like 10 years from now, but today, we believe the commonwealth does not face a near-term default, and that fund managers who shun the region are paying an opportunity cost.
On Aug. 26, 2013, an article on the cover of Barron’s highlighted Puerto Rico as the next Detroit. Though the two may share similarities like declining and weak economies, persistent budget deficits, and onerous debt, there are three significant differences worth noting.
- Timeline of their declines — Detroit’s finances have been on a downward path for 60 years; meanwhile the Puerto Rican economy will soon be entering its seventh year of recession.
- Steps taken by leadership — Detroit’s emergency manager, Kevyn Orr, presented a debt-restructuring plan that offered an unpalatable 10 cents on the dollar on some of the city’s unfinanced debt obligations. His plan was interpreted by creditors as an unwillingness to make the compromises needed to keep the municipality out of bankruptcy. In contrast, Puerto Rico has taken painful and politically unpopular steps to avoid restructuring and default. A new government elected in 2012, led by the populist Governor Alejandro García Padilla, is committed to putting Puerto Rico and its various bond-issuing authorities on a stronger financial footing.
- Market demand – Debt issued by Puerto Rico has a strong investor base given its “triple” tax exemption — federal, state, and local — which is rare in the municipal market. The debt issued by the commonwealth is not only in high demand by national municipal funds for the triple tax-exemption, but also by single-state municipal funds, who use the debt as a diversifier. By contrast, debt issued by Detroit does not have a distinct investor base, therefore demand for the debt is a fraction of that of the commonwealth.
1 Source: Commonwealth of Puerto Rico, Financial Information and Operating Data Report, May 17, 2013.
2 Source: Barron’s, “Puerto Rico in Trouble,” Aug. 26, 2013.
The risks of investing in securities of foreign issuers can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
The performance of an investment concentrated in issuers of a certain region or country is expected to be closely tied to conditions within that region and to be more volatile than more geographically diversified funds.
Municipal securities are subject to the risk that legislative or economic conditions could affect an issuer’s ability to make payments of principal and/ or interest.
Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.