The Sunday, June 25, New York Times article “After Puerto Rico’s Debt Crisis, Worries Shift to Virgin Islands” highlights recent developments concerning the Virgin Islands territory’s lack of market access, drawing a parallel to Puerto Rico and assessing the potential for contagion to other US territories: – Guam, American Samoa, and the Northern Mariana Islands.
It also produces “headline risk.”
Similarly, S&P’s announcement yesterday that it has downgraded National Public Finance Guaranty (National) to A from AA- also produces headline risk. The rating was downgraded because National’s business risk profile is weaker than those of its peers as it struggles to gain market acceptance. S&P notes the low risk-adjusted pricing the company has engaged in to try to gain market share. Although National’s market share is improving, it is lower than that of its peers.
Importantly, S&P further states, with regard to National's financial risk profile, that the company's capital adequacy is very strong, with a capital adequacy ratio in excess of 1.0x.
Nevertheless, S&P’s announcement generates “headline risk.”
The spread between AGM-insured Puerto Rico and National-insured Puerto Rico does not seem to have changed appreciably, because the S&P “Credit Watch” announcement on June 6th allowed market adjustment and because National’s claims-paying resources remain strong.
Regarding the US Virgin Islands (USVI), common stresses of territories include underfunded pension plans and reduced economic activity or loss of employers due to intrinsic or extrinsic factors or expiring tax incentives. The NYT article discusses the question of whether the federal government’s allowing Puerto Rico to enter into restructuring negotiations per PROMESA has increased the risk that other territories might more easily follow suit. USVI has lost market access, though recent tax collections and smaller payments to the already underfunded pension plan have, for now, alleviated an all-out cash crunch. It does not appear that there is another liquidity source available to the USVI. The article mentions the territory’s desire to make good on its debt obligations and the specific steps USVI has taken to enhance revenues, including raising taxes and fees, garnering more Medicaid funding, and reaching out to the federal government with a request for tax incentives for tech companies. Time will tell whether changes are made and those efforts are enough.
The article also notes that “PROMESA appears to shred the many legal mechanisms governmental borrowers use to secure their debt.” In particular, USVI uses a lockbox mechanism by which sales taxes flow directly to the trustee for bondholders and those funds are collected until the annual debt service has been satisfied; then the remaining revenues flow to the territory. This structure is similar to the COFINA or sales tax bonds issued by Puerto Rico – bonds which, when issued, received a higher rating than GO debt did because of their lockbox structure. The trustee for COFINA asked a court how to treat the revenue. Currently, revenues are not flowing to bondholders, and there has been a default. Wrangling between the commonwealth and bondholders continues on this topic. Meanwhile, insured Puerto Rico debt holders continue to receive regularly scheduled principal and interest payments.
In Puerto Rico the future ability to issue COFINA bonds or utilize similar structures was seen as a way for the island to access the markets with a potentially higher rating than for GO bonds. Now, depending on the outcome of the Puerto Rico negotiations, that recourse may have been lost, and the security of other similarly structured transactions has become problematic. Contagion risk could potentially call into question all lock-box types of financings. However, it should be noted that the underlying credit characteristics of an issuer, such as diversity of the service area economy, wealth and income levels, financial operations, and leverage are all very important to credit quality. Additionally, a bond’s security provisions are always important, and becomes more important in stressful situations.
At Cumberland we continue to follow developments in the credit markets, including Puerto Rico and the bond insurers. We remain confident in the ability of the bond insurers to pay claims at this time and see any weakness from headline risk as a potential buying opportunity. It is sometimes convenient to lump credits together based on contagion risk, however each credit situation is different and must be analyzed on its own merits to determine opportunities.
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