Puerto Rico Gov. Alejandro García Padilla may have worsened relations with traditional municipal investors when he acknowledged long-standing concerns that the commonwealth cannot pay its $72 billion in municipal bond debts.
"This is very much what we expected," said John Mousseau, executive vice president and director of fixed income at Cumberland Advisors in an interview on Monday morning. "I don't think he's stretching the truth."
While the market has expected news of a possible default for months, the debate over tactics in what is already seen as the biggest fiscal debacle in municipal bond history is likely to intensify, increasing the role of non-traditional investors such as hedge funds, they said.
"We believe the latest news marks an important shift in Puerto Rico's strategy to keeping its government and essential services operating," said David Litvack, managing director and head of tax exempt research at U.S. Trust.
"Rather than looking to borrow new funds, it apparently will seek to preserve cash by not paying its creditors. The situation is extremely fluid right now, and investors should expect significant volatility in Puerto Rico securities over the near-to-intermediate term."
Dick Larkin, senior vice president and director of credit analysis at Herbert J. Sims & Co., characterized the latest admission by the governor as a continuation of "ill-advised" mistakes that are condemning Puerto Rico to "financial suicide."
"I think he's making a disastrous mistake based on bad financial advice," Larkin told the Bond Buyer Monday afternoon.
Larkin said there are still alternatives to bankruptcy or default.
Among the steps Larkin said the commonwealth needs to follow to financial recovery are: formulating its annual budget sooner, and establishing a credible five-year financial plan - the first year consisting of the budget and four years of credible projections.
He also said the island needs to have regular candid meetings between governor, legislative leaders, and the Government Development Bank -- if it still exists - as well as mending fences with the major rating agencies to establish better lines of communication in the effort to work toward returning to investment grade status in the future.
Jeffrey Lipton, managing director and head of municipal research and strategy at Oppenheimer & Co., agreed that the affirmation of the market's expectations sends a negative message at a crucial time.
"Clearly, the Governor is backing away from his long-standing position of protecting the general obligation and central government credits," Lipton said.
Lipton expects a restructuring to be extensive. "The question remains: how much of the outstanding $72 billion in Island debt will be enveloped within the restructuring," he said.
The news Monday did not appear to hurt the overall municipal market, but the secondary market for Puerto Rico paper swooned.
Puerto Rico commonwealth Series 2014A general obligation 8s of 2035 were trading as low as 68.50 cents on the dollar on Monday, according to the Municipal Securities Rulemaking Board's EMMA website, a high yield of 12.255%. There were 37 trades totaling $86 million; 16 customers sold the bonds, 17 customers bought them while four were done as inter-dealer trades.
On Friday, the GOs traded as low as 76.75, according to EMMA, a high yield of 10.874%. There were 19 trades totaling $22 million; 10 customers bought the GOS, three sold them while six were done as inter-dealer trades.
"The news is negatively affecting both GO and revenue paper," a Markit analyst told The Bond Buyer.
He cited the Puerto Rico Public Buildings Authority's 2012 Series U government facilities revenue refunding 5 1/4s of 2042, which were trading in the 55 range on Monday after being evaluated at 60 on Friday. Markit also reported the commonwealth's Series 2012A GO public improvement refunding 5s of 2041 were trading at 59.25, compared to 64 on Friday.
"The important thing is municipals are moving in the same direction [as Treasuries] and not in the opposite direction, which would be the case if the market thought [a possible default by Puerto Rico] was indicative of more problems across the board," Mousseau said.
"If people didn't think there was a solution down there, you'd have a flat yield curve, but you have an inverted yield curve," he added.
Mousseau is among those surprised that U.S. Congress appears unwilling to provide assistance - including having no desire to fast track the island's statehood or provide fiscal assistance.
"I think it's awful that a U.S. territory will default," he said. "I think it's a bad message to send to all the people that own U.S. debt that we will sit idly by and let a territory go under without doing anything."
"You don't have to picking up the cost of the debt to be doing more," he said of Congress. "They should be crafting other ways of assistance."
Mousseau is speaking Tuesday in Washington at an American Enterprise Institute's seminar on Puerto Rico as the next Greece.
Municipal strategists and experts said they believe the island's restructuring will now be accelerated.
"The size of the total debt of the Commonwealth made a restructuring unavoidable. Now, it's more likely that it will get to that goal sooner," agreed David Tawil, president of hedge fund Maglan Capital.
To say the recovery process will be a long road is an understatement, municipal experts said.
"I think that any remaining retail investors should be flushed out now," said Tawil of Maglan Capital.
"Puerto Rico is entirely the domain of hedge funds and the mutual funds that have made distressed munis part of their universe."
Phil Fischer of Bank of America Merrill Lynch said García Padilla is "simply confirming what the market has concluded for a long time."
Fischer went as far as saying the island should be considered a foreign country and said he didn't expect any involvement by Congress to assist the commonwealth with its investment debt.
"We don't think the Congress will provide Chapter 9 relief or react to help bond holders," Fischer said. "Puerto Rico is not a state and for these purposes we should think of it as a foreign country," he said.
"The Puerto Rico people will receive whatever aid is necessary for their health and welfare, but we should not expect Congress to offer debt relief for investors," Fischer added.
Others, meanwhile, spoke of the precarious road ahead for the island.
"There are both short and long term issues which doesn't make for a very optimistic outlook," said Alexandra Lebenthal, president and chief executive officer of Lebenthal.
"There are three issues to be solved, any one of which on its own is gargantuan -- finding the cash to pay current interest payments, restructuring long-term debt, and still trying to right the commonwealth's economic structure so that it can be viable long term," Lebenthal said.
"You cannot continually kick the can down the road," she added.
Sustained financial recovery of Puerto Rico will hinge on steady, consistent and long-term growth in population and productivity, as well as the economy in excess of debt accumulation, including pensions, according to Chris Mier, managing director of analytical services at Loop Capital Markets.
"A restructuring may buy some time," Mier said. "But it comes at a significant cost to Puerto Rico and to the bondholders, and will not fix the island's problems until the three conditions, at minimum, are met."
