If Congress makes Puerto Rico a U.S. state, it would both positively and negatively impact its finances and its outstanding debt, analysts say, but the loss of the triple-tax-exemption would diminish its buyer base for future deals.
In November, 52% of Puerto Rico voters voted for statehood in a non-binding advisory referendum and currently there are two bills in Congress that could lead to statehood.
This is not, of course, the first time the question of statehood for the territory has arisen — November's vote was the sixth status referendum since 1967 — and it has never gained enough momentum in Washington to come to fruition.
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One of the biggest effects of statehood for Puerto Rico would be the loss of its unique triple-tax-exemption. Any new bonds sold by a state of Puerto Rico would not benefit from the tax-exemption from local, municipal, and federal taxes that have historically drawn many U.S. investors to the island's debt.
Only those who reside in Puerto Rico would still enjoy an exemption from state and municipal-level income taxes on the bonds’ interest if it becomes a state. There is no accurate public figure but in recent years some have estimated that Puerto Rico residents own 20% of the commonwealth's bonds.
Aside from the loss of the triple-tax-exemption, “it’s hard to see Puerto Rico being worse off, or less able to raise capital, if it were a state vs. current status,” said Municipal Market Analytics Partner Matt Fabian.
“We have a hard time seeing Puerto Rico statehood as a negative scenario for bondholders, arguing that a material portion of Puerto Rico’s past financial and economic troubles reflected Puerto Rico’s pervasive reliance on a disinterested and uninvolved U.S. Congress," analysts wrote in the April 19 MMA Outlook. "Further, any transition from territory to state would require substantial revenue and administrative reforms and would reasonably involve years of related preparation.”
After statehood, bond investors outside of the island would be less interested in Puerto Rico bonds, said Bob Chirinko, professor of finance at University of Illinois at Chicago. To entice investors, Puerto Rico’s government issuers would have to pay higher interest rates than they otherwise would. Puerto Rico already would pay a premimum given its fiscal disarray.
Future issuance has less to do with statehood and more to do with debt capacity, ratings potential, and economic growth, a bondholder said.
"Buyers would be just as they are in the muni market is today, mostly traditional investors, although they would no longer be triple tax-exempt for all buyers so spreads would be higher," the bondholder said. "But that will be an issue they face as a result of fiscal health anyways.”
The loss of the triple-tax-exemption would eliminate the demand from single-state municipal bond funds to hold Puerto Rico paper. Such funds are structured to maximize their buyers’ state and federal tax advantages.
Some held as much as 40% of Puerto Rico’s debt before the commonwealth went into Title III, though anecdotally those figures have come down from pre-bankruptcy peaks.
As for existing outstanding Puerto Rico bonds, they would likely see their tax-exemption for state-side residents grandfathered in, which would also make them scarcer and more valuable as a result. If the bonds were refinanced, then the triple exemption would not be allowed.
"Remaining Federally exempt [after statehood] seems most likely but bond counsel would need to verify that all the Puerto Rico bonds comply with all the terms under the traditional tax-exemption section of the code," Fabian said.
Others saw the future for the bonds as being more mixed or dependent on undetermined factors. One analyst said any new Puerto Rico bonds were likely to carry high interest rates in the next few years until “the credit picture is completely rehabilitated.”
Before statehood would even be implemented, Puerto Rico would need to exit its bankruptcy.
According to the Puerto Rico Oversight, Management, and Economic Stability Act, Puerto Rico has to have structurally balanced budget for four years before the board can dispose of itself and give way to local rule. The government cannot have even its first structurally balanced budget until the central government debt deal is approved and it begins to make debt service payments on the restructured debt.
Before Puerto Rico became a state, Congress would have to either observe the four-year period or amend PROMESA. A state government cannot be under the control of a federally appointed board.
Chirinko said PROMESA is the “wild card” in statehood, as its “existence seems predicated on Puerto Rico’s unique territorial status.”
The question of how pre-statehood bonds are treated post-statehood does have precedents.
Congress made Hawaii a state through the Hawaii Admissions Act in 1959, which specified territorial laws were to be transferred into state laws. This law meant the federal government continued to observe the tax-exemption of Hawaii bonds in the decades that followed, said William Yuen, partner in the Honolulu branch of Dentons.
In 1964 the California Franchise Tax Board ruled that the interest on Hawaii and Alaska bonds issued before statehood should retain their exemption from California taxes.
In 1914 the U.S. Supreme Court suggested that Oklahoma bonds pre-statehood should retain their tax- exemption from other states’ income taxes.
Some observers said statehood might benefit outstanding bonds. Arturo Porzecanski, Hurst Senior Professorial Lecturer at American University, said statehood would make the bonds safer since federal law prohibits states from filing for bankruptcy.
If Puerto Rico were to become a state, it would likely “benefit in a number of ways from existing federal programs that reallocate resources from the richer to the poorer states,” Chirinko said.
The rating agencies could potentially upgrade outstanding Puerto Rico debt due to the stronger fiscal ties to the Federal government.
In a comment released on Nov. 4, Moody’s Investors Service made a similar point. “Providing adequate funding under the Medicaid healthcare program is a long-standing credit challenge for the commonwealth,” said Vice President Genevieve Nolan and five other analysts. Becoming a state would convert ad hoc Congressional help to mandated help and increase the federal contribution.
Puerto Rico would be come eligible for the federal Supplemental Nutritional Assistance Program and Supplemental Security Income programs and it would get more money for Medicare, Moody’s said.
If Puerto Rico were to become a state, island residents would have to start paying federal income taxes. However, nearly 80% of them would fall into the two lowest federal tax brackets of 12% or less, Moody’s said.
“Some business investment … could increase due to the perceived greater political stability stemming from statehood, as opposed to Puerto Rico remaining a territory,” Moody’s said.
The impact of statehood on the bonds may be academic for the near future, however. Several analysts said statehood was unlikely to happen any time soon.
“I am skeptical that there is sufficient political will for statehood in Congress and I think it will likely only happen if packaged with [Washington,] D.C. statehood,” the bondholder said.
Others said the political climate in Washington also throws a wrench in statehood for the island.“An affirmative Puerto Rico vote [by its people] needs to be complemented by a positive vote in both houses of the U.S. Congress," Chirinko said. "The Republicans are unlikely to favor giving approximately six electoral votes to the Democrats.”
Along with electoral votes, statehood would give Puerto Rico two U.S. senators and four members of the U.S. House of Representatives. Currently it only has Jenniffer Gonzalez Colón in Congress. She can vote in committees but not on the House floor.
Porzecanski said Congress would have to be “comfortably in the hands of the Democrats” for at least four years for a Puerto Rico statehood bill to have a chance of passage. Additionally, D.C. likely would first have to become a state before granting Puerto Rico that status. Others noted that Puerto Rico would have to emerge from its bankruptcy.
Statehood may not be the only possible new status for the island. Some island residents say Puerto Rico should be an independent nation and others say that it should have a semi-independent affiliated status. One of the bills currently in Congress that could lead to statehood, authored by Rep. Nydia Velazquez, D-N.Y., would have island residents elect delegates to a Constitutional Status Convention to choose among several status options.
