Municipal bond issuers’ willingness to pay their debts has emerged as a disturbing issue as a result of Puerto Rico’s attempts to avoid making debt payments. At the recent AFGI Puerto Rico Bankruptcy Summit in New York, Assured Guaranty President and CEO Dominic Frederico discussed how the situation in Puerto Rico could gravely affect the overall municipal bond market, financing costs for state and local governments across the United States, infrastructure development and tax rates and fees for U.S. citizens across the country.
The $18 trillion U.S. economy rests on a vast and decaying infrastructure, he noted, including bridges, tunnels, roads and airports. The American Society of Civil Engineers forecasts it will take about $4.6 trillion through 2025 to raise the grade of the infrastructure from a rating of D+ to B.
The largest, most reliable way to pay for infrastructure and related government services is the U.S. municipal bond market, Mr. Frederico noted. Currently, this market is comprised of $3.7 trillion of municipal debt outstanding, with more than $2 trillion held by individual investors either directly or through mutual funds. Keeping infrastructure borrowing costs down depends on reducing uncertainty for potential investors. And that, in turn, depends on the enforceability of contracts and borrowing documents, and the adherence to the rule of law.
Purchasers of municipal bonds have typically focused almost exclusively on an issuer’s ability to pay. Investment grade municipal credits have historically almost never defaulted — and investors have trusted that documents written by lawyers conform to accepted legal and market practices for risk disclosure.
In the wake of Puerto Rico’s defaults, however, “willingness to pay has become a major issue,” said Frederico. And that risk cannot be quantified and is more difficult to predict than ability to pay because there is no guarantee that future government officials will stand by their predecessors’ contracts and pledges.
Puerto Rico historically had no means to restructure its debt through bankruptcy as it was specifically excluded from the Chapter 9 municipal bankruptcy provisions, Mr. Frederico explained. This fact was emphasized by Puerto Rico in the marketing of the bonds it sold. In 2014, the commonwealth attempted to break its no-bankruptcy representation by enacting a new law allowing public corporations to forcibly restructure debt. This law violated the federal bankruptcy code and was struck down by the District Court and ultimately by the U.S. Supreme Court.
However, in 2016, after the federal PROMESA act gave Puerto Rico a method for debt restructuring, Puerto Rico simply stopped paying any debt service on its general obligation bonds and has paid nothing since, in an outright violation of the law, asserted Mr. Frederico. The Puerto Rico Constitution requires making G.O. Bond payments ahead of any other expenses.
In 2017, Puerto Rico sought to restructure, under Title III of PROMESA, about $72 billion of its debt obligations. As part of this process, the Title III Court ruled that municipalities are not required to make payments on debt secured by special revenues while bankruptcy proceedings are ongoing; instead, municipalities can voluntarily opt to make the payments. Assured Guaranty, a leading provider of financial guaranty insurance and one of the island’s creditors, was one of the plaintiffs that appealed the ruling, which the First Circuit Court of Appeals affirmed on March 28, 2019. According to Mr. Frederico, the First Circuit Court decision misinterprets or misrepresents provisions of the bankruptcy code enacted precisely to prevent such an interruption of special revenue debt payments during municipal bankruptcy. The decision “rejects established market understanding of special revenue bond treatment during bankruptcy,” asserted Mr. Frederico. “If not corrected, it would create new uncertainty for investors.”
“The consequences are not limited to Puerto Rico,” said Mr. Frederico. “If the ruling stands, revenue bond investors will have to price in new risk, which means higher interest rates for future revenue bond issuers and higher costs to finance essential infrastructure development.”
For example, the National Federation of Municipal Analysts (NFMA) predicts the costs for highly rated credits could rise 5 to 10 basis points, and 30 to 50 basis points for lower-rated credits. This could amount to as much as $6.2 billion in additional costs on $750 billion issuance of infrastructure revenue bonds over 10 years.
Compounding the problem, Puerto Rico’s federally appointed Financial Management and Oversight Board is trying to repudiate $6 billion of constitutionally protected Puerto Rico G.O. Bonds and wants to recover what has already been paid to bondholders.
“Going forward, how do you price the risk that a general obligation issuer can simply walk away from its contractual obligations?” asked Mr. Frederico. “This tactic should raise concerns for all municipal issuers, their advisors and especially their investors.”
“The risk of contagion is real,” Mr. Frederico emphasized. “Everyone will pay.”