This article was first published at The McAlvany Intelligence Advisor on Wednesday, October 30, 2013:
The complacency of municipal bond holders ended in July with the filing for bankruptcy by Detroit, an unhappy town of just 700,000 owing more than $18 billion to investors. Haircuts there have variously been estimated to be between 15 and 60 percent.
Since then, those holders have been looking around to find the next shoe to fall, and they have found it: another unhappy place 1500 miles south in the Caribbean, the island of Puerto Rico.
A protectorate or territory of the US (actually the relationship is that of a suzerainty), Puerto Rico has long lived way beyond its means, but the chickens are just now coming home to roost. It has sustained itself in the never-never land of deficits and increasing national debt (now over $70 billion and counting) by two primary subsidies, thanks to the US: a favorable tax code which, until recently, allowed American companies with branches in Puerto Rico to send their earnings back to their parent without any corporate income tax, along with triple-tax-exempt status on its bonds (federal, state, and local) which has made their bonds artificially attractive to US bondholders who weren’t paying attention.
Those bondholders are paying attention now. A close look at what’s been happening in Puerto Rico is unnerving. With the favorable corporate income tax relief in place, the island became a sanctuary for companies to set up “maquiladoras” – manufacturing operations in a tax-free zone where they import materials and equipment on a duty-free and tariff-free basis. Drug companies in particular found the island a great place to operate, but they and others left when the tax relief expired in 2006.
The Great Recession only deepened the island’s recession. Moody’s downgraded the country’s debt to just above junk in early October. A branch of UBS just settled with the SEC for hiding the country’s desperate financial condition and artificially supporting bond prices. And the treasury found its access to the bond market for a new issue so unfavorable that they had to resort to short-term bank financing and a private placement with interest rates approaching 12% in five years if it hasn’t been paid back by then.
The list of difficulties goes on:
The US-enforced minimum wage puts large numbers of potential workers on the streets, resulting in an unemployment rate twice that of the US. Labor participation is 41% compared to 63% here, the country’s national debt is larger than any American state except California and New York, and the ratio of the national debt to personal income (which is 3.4% stateside) is a jaw-dropping 89%.
In 2006, the country’s president cut taxes in order to stimulate the economy, but the strategy wasn’t allowed enough time to work. He was replaced by a hard-line socialist who just raised taxes as part of his plan to balance the budget by 2016. Of course, he didn’t do anything about the disincentives of overly generous welfare and disability income programs that discourage employment and encourage dependency. And he certainly didn’t shrink government – one out of five workers who actually have jobs work for the government.
The country’s pension plan is only 7% funded, and its 2012 Comprehensive Annual Financial Statement that was due months ago has been delayed still further.
So how are those bondholders faring, in light of all of this? Not surprisingly, their statements are disheartening to say the least. 180 high yield municipal bond funds have been sucking up Puerto Rican debt in order to satisfy their investors’ demands for cash flow. In some high-income tax states, yields of up to 16% equivalent were being enjoyed along with the assurance that their capital was safe. Not any longer. The Franklin Double Tax-Free Income fund has a 60% exposure to Puerto Rican debt, and investors have seen their NAVs drop by three percent every month since May. That translates to one-sixth of their capital disappearing in just five months.
Investors in UBS’s Puerto Rico Tax-Free Target Maturity Funds I and II have nearly been wiped out, suffering losses of 88.9% and 83.5% respectively. This portends ill for the municipal bond market as a whole – which market, by the way, is $4 trillion! The ripple effect from the Caribbean will likely impact borrowing costs from Dubuque to Daytona, raising the cost of government borrowing just when states were beginning to see the light at the end of the very long five-year tunnel.
All of this was predictable, of course. It’s the welfare state in motion, proving once again, if proof be needed, that interventions, subsidies, minimum wage laws, and overly generous pension and welfare programs all work together to slow down, stop, and reverse the progress gained by the free market. In Puerto Rico, investors and others are seeing, in microcosm, what is happening in the US. Puerto Rico is not Detroit, nor Greece, nor Italy, nor Spain. It is in fact the US.
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Sources:
The Economist: Puerto Pobre – A heavily indebted island weighs on America’s municipal-bond market
The Economist: Greece in the Caribbean
Wall Street Cheat Sheet: What’s Next in Wake of Puerto Rico Municipal Bond Crisis?
Barrons: Washington Getting Worried About Puerto Rico Debt
MorningStar: Feeling the Heat From Puerto Rico
USAToday: Puerto Rico’s debt woes hit muni bond funds
Reuters: Puerto Rico’s borrowing goes private
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