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Posted on OCT 9, 2017

From Bad to Worse

Written by Craig Mauermann, VP, Wealth Fund Manager, Fixed Income

Following back to back hurricanes, Puerto Rico's slow recovery and precarious financial condition continue to make daily headlines. While we don't have exposure to Puerto Rican bonds in our accounts, we understand that many of our customers may hold bonds from one or more Puerto Rican agencies in self‐directed portfolios. This update is provided on behalf of those who have exposure or interest.

Earlier this year, we shared a presentation on Puerto Rico in which we were less than optimistic about the future of the island in the near‐term due to a massive debt load that appears to be far in excess of what government and municipalities can pay. Puerto Rico has annual GDP of $103.6 billion and a population of just 3.4 million people, yet has debt totaling $74 billion and is losing about 50,000 residents per year.

The September hurricanes have further burdened Puerto Rico's already precarious financial situation. Category 5 Hurricane Irma passed just north of San Juan on Sept. 6, cutting off power to two thirds of the island and access to clean drinking water for one third of residents. Supplies on the island were adequate to get most of the island working again within ten days, but there were still more than 50,000 customers without power two weeks later. That's when a direct hit by Category 5 Hurricane Maria on Sept. 20 took out power to the entire island, eliminated clean drinking water to most residents, left many roads impassable due to debris, and wiped out thousands of homes and businesses. In the days following the storm, Puerto Rican officials coordinated with FEMA and the Pentagon to begin shipping and airlifting a massive amount of emergency aid, generators and fuel to establish a network of relief stations across the island.

More than two weeks have passed since Hurricane Maria hit, and island residents are slowly seeing progress. There are about 25 emergency aid stations, at least two thirds of the island's 1,100 gas stations are selling gas, and about two thirds of grocery stores and big box retailers are open, though not necessarily fully stocked.

Puerto Rico's Outstanding Debt

To fully understand the impact of the storm, it's necessary to first understand the issue of the overwhelming debt owed by the island and its dozen or so borrowing agencies.

Tabling showing each borrowing agency and how much outstanding debt for each.

As is obvious from looking at the names of the agencies above, the hurricane damage is only going to make things worse. The island will not be able to assess as much in property taxes on properties that are now severely damaged or destroyed. The Electric Power Authority (PREPA) is losing revenues while its customers are without power, and the entire power grid needs to be rebuilt at a cost that could be billions of dollars. Likewise, the water and sewer authority is losing revenues and needs to rebuild significant portions of its infrastructure. Essentially, a bad situation has become far worse.

The Hurricane Crisis and Its Impact on Bonds

So what impact have the hurricanes had on Puerto Rico's bonds? As you can imagine, bonds that were already highly distressed have since traded lower, in two phases. A commonly quoted Puerto Rico bond with an 8% coupon maturing in 2035 traded around 58 to 59.5 cents on the dollar in late August. As the first hurricane approached in early September, the bonds traded down a couple of percentage points to about 56.7 cents but actually rebounded because the first hurricane's destruction was considered very manageable. A bigger impact was felt after Maria swept through and it became clear to the markets that the second storm was epic in magnitude. Bonds fell to under 53 cents five days after Maria, then to under 49 cents three days after that, and down to about 46 cents by Oct. 3.

The market moves were far from over. Later in the day on Oct. 3, after spending several hours touring and assessing damage in Puerto Rico, President Trump commented that, in light of the damage on the island, the U.S. would have to erase Puerto Rico's debt. Specifically, he said to a Fox News reporter, “They owe a lot of money to your friends on Wall Street and we're going to have to wipe that out. You can say goodbye to that.”

That fairly straightforward message from President Trump, while certainly not in accordance with current laws or precedents, had an instant chilling effect on bond pricing. When the bond market opened the following morning, the bonds were down more than 10 additional percentage points, trading as low as 30.25 cents and averaging 35.6 cents throughout the day. The bonds ended the week last Friday, Oct. 6, trading at an average 38.1 cents.

Tabling showing the bond market since early 2016.

This information is for educational and illustrative purposes only and should not be used or construed as financial advice, an offer to sell, a solicitation, an offer to buy or a recommendation for any security. Opinions expressed herein are as of the date of this report and do not necessarily represent the views of Johnson Financial Group and/or its affiliates. Johnson Financial Group and/or its affiliates may issue reports or have opinions that are inconsistent with this report. Johnson Financial Group and/or its affiliates do not warrant the accuracy or completeness of information contained herein. Such information is subject to change without notice and is not intended to influence your investment decisions. Johnson Financial Group and/or its affiliates do not provide legal or tax advice to clients. You should review your particular circumstances with your independent legal and tax advisors. Whether any planned tax result is realized by you depends on the specific facts of your own situation at the time your taxes are prepared. Past performance is no guarantee of future results. All performance data, while deemed obtained from reliable sources, are not guaranteed for accuracy. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment losses. Certain investments, like real estate, equity investments and fixed income securities, carry a certain degree of risk and may not be suitable for all investors. An investor could lose all or a substantial amount of his or her investment. Johnson Financial Group is the parent company of Johnson Bank, Cleary Gull Advisors Inc. and Johnson Insurance Services LLC. NOT FDIC INSURED * NO BANK GUARANTEE * MAY LOSE VALUE


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