Washington holds key for Puerto Rico bondholders

As Puerto Rico faces upcoming deadlines for paying bondholders and other creditors, all eyes are turning to Washington with hopes that the White House, Congress or even the Supreme Court can work out a solution.

No one expects a clear victor, but the practical solution could at least share the pain, observers say.

There are many moving parts, including 20 classes of creditors holding as much as $72 billion in bonds and expecting $2 billion in debt payments in May and June.

With no resources to tap, the commonwealth has resorted to extreme measures, including borrowing from a nearly depleted pension fund, to pay bills and bondholders.

Pension liabilities of the Puerto Rico Employees' Retirement System, Hato Rey, are now $46 billion. A Treasury Department analysis in October noted that because Puerto Rico failed to make annual contributions in the past decade, the fund is selling assets to pay current benefits, making total asset depletion likely by 2019.

Antonio Weiss, counselor to Treasury Secretary Jacob Lew, told a congressional panel earlier this year that the pension fund now has $2 billion in assets.

About one-third of annual revenue is consumed by tax-supported debt service. With total liabilities exceeding 160% of GDP, Puerto Rico's debt load is unsustainable, Treasury officials said. “All stakeholders, including bondholders, need to be part of the solution,” Mr. Lew told Congress last year.

At a White House meeting of Puerto Rican interest groups in February, Mr. Lew said it will take “new tools,” including independent fiscal oversight and an orderly process for debt restructuring that has to come from Congress.

Such uncertainty “is already having an effect on the marketplace,” said Hector Negroni, co-CEO and chief investment officer of Fundamental Credit Opportunities, New York, at a February gathering hosted by the Bipartisan Policy Center in Washington. “The global investment community is very interested (in investing in Puerto Rico). They just want to wade into less choppy waters,” he said.

Groups dig in

Most U.S. defined benefit and defined contribution plans, endowments and foundations don't invest in tax-exempt debt, but some of their money managers, especially high-yield debt managers and distressed debt hedge funds, have exposure to the island's financial crisis through their bond holdings.

According to specialty researcher Municipal Market Analytics Inc., Westport, Conn., hedge funds, mutual funds and retail investors each hold about one-third of the debt.

Those hedge fund firms include Angelo Gordon & Co., BlueMountain Capital Management LLC, Brigade Capital Management LP, Centerbridge Partners LP, Davidson Kempner Capital Management LP, Fir Tree Inc., Knighthead Capital Management LLC, Marathon Asset Management LP, Monarch Alternative Capital LP, Stone Lion Capital Partners LP and D.E. Shaw Group, according to court documents and Bloomberg reports.

Traditional money managers that own Puerto Rican municipal bonds include Franklin Advisers Inc., Fundamental Advisors LP, Goldman Sachs Asset Management and OppenheimerFunds.

Some bondholders have formed ad hoc restructuring groups, depending on the specific kind of bonds they hold, such as those of the Puerto Rico Electric Power Authority.

Questions about Puerto Rico's ability — both legal and financial — to restructure its debt has bondholder groups digging in while Congress and the White House try to come up with solutions.

The main challenge before Congress is to address U.S. bankruptcy law that specifically excludes Puerto Rico from that option. After proposals to change that failed to gain traction, the House Committee on Natural Resources, which has jurisdiction over U.S. territories, on March 29 floated a discussion draft of legislation seeking a middle path. It included an independent oversight board to appease critics of Puerto Rico's spending habits, ideas for spurring private investment and provisions for voluntary restructuring with some creditors.

The new board could authorize bankruptcy petitions “as a last resort,” according to the draft.

The legislation is slated for official release April 11 and a hearing two days later, with “conversations between now and then,” said a committee staffer who attributed much of the urgency to concern for pensioners. For debtholders, “we don't seek to preserve one right over another. ... Our goal is try to get things done as quickly as possible,” he said.

A leading group of bondholders wasted no time criticizing the proposal.

“The discussion draft bill is worse for creditors than Chapter 9,” said financial adviser Stephen Spencer of Houlihan Lokey, Washington, who represents major Puerto Rico creditors, including OppenheimerFunds and Franklin Advisers.

The PREPA Bondholder Group, which includes BlueMountain Capital Management, Marathon Asset Management, Knighthead Capital Management, Franklin Resources, Oppenheimer, D.E. Shaw Galvanic Portfolios and Angelo Gordon, “are lobbying the issue very actively,” said a financial services lobbyist who declined to be identified.

Some general obligation bond investors are less committed, he said. “They may feel like they don't have a stake, and might be better off under” the bankruptcy process or other restructuring.

One proposal from a Puerto Rico working group would have creditors holding $49 billion of tax-supported debt exchange it for two new securities with better collateral security and liquidity.

Another group of Puerto Rico bondholders with $7 billion of senior bonds issued by government entity Cofina has proposed a payment plan protecting their holdings and allowing the commonwealth to limit and extend interest payments, as opposed to eliminating protections to investors who thought bankruptcy was not a remote possibility.

Despite the political sensitivity of a control board, “the reality is that, if Congress is going to provide Puerto Rico with reasonable debt restructuring authority, it will be coupled with a fiscal oversight board,” Puerto Rico Resident Commissioner Pedro Pierluisi said in a statement March 29. “However, the oversight board must have teeth, but not fangs.”

Bankruptcy an option?

Some Capitol Hill watchers think the likeliest scenario is that PREPA will default, followed by other bond issuers.

“It's just a matter of time before PREPA misses a payment, and as soon as they do, they (bondholders) will move to get paid,” said the lobbyist. If there is a default, a receiver would have to prioritize payments to creditors, which could be better for the bondholders than what a bankruptcy judge would do.

Allowing bankruptcy as an option for Puerto Rico depends on action by Congress or the Supreme Court.

Puerto Rican officials were pleasantly surprised when the Supreme Court agreed to take a case challenging two lower court decisions that invalidated Puerto Rico's 2014 restructuring law. That law would allow Puerto Rico to take advantage of U.S. bankruptcy law that specifically excludes Puerto Rico.

During March 22 oral arguments on the combined cases of Puerto Rico vs. Franklin California Tax-Free Trust and Acosta-Febo vs. Franklin California Tax-Free Trust, several justices seemed sympathetic to Puerto Rico's plight.

“Why would Congress put Puerto Rico in this never-never land?” asked Justice Ruth Bader Ginsburg. “What explains Congress wanting to put Puerto Rico in this anomalous position of not being able to restructure its debt?” she asked.