Many events have transpired after we wrote our first research piece on Puerto Rico (“PR”). Back then we were worried about the lack of fiscal restraint at the onset of 2013, the lack of political will and the ability to rein in fiscal spending and enact structural reforms. All these against a backdrop of rising interest rates. Furthermore, we dwelled on the structural dislocation between locally issued bonds (which were tax exempt for PR residents while taxable for US residents). At the time, these bonds were trading in line with the triple tax exempt bonds, highlighting the issue, that could result in a significant repricing of the taxable bonds to come in line with the after tax yield of the tax exempt bonds.

Fast forward to today and after going through a lengthy and painful bankruptcy process, many of the issues that plagued the PR credit spectrum have been addressed and resolved. For once, there is no longer an isolated bond market in PR where taxable bonds, offered to PR residents as tax exempt, trade on their own supply/demand dynamics. The entire restructured curve now trades in the same transparent market with the same tax implications for both on-island investors and mainland investors. Hence, there is no longer a liquidity gap between the two different markets. There is no threat of sudden supply increases due to levered investors seeking to fulfill margin calls or redemptions. Investor positioning is attractive as it has now become an underexposed, under owned credit; frowned upon and misunderstood by many. This is our attempt to explain, in as much detail as possible, why we are constructive on PR bonds and the economic outlook of the island.

The inflection point for PR was the “me vale” (I don’t care) expression made by former governor Garcia Padilla during an interview with the press when asked about the negative assessment by the rating agencies on his increased fiscal spending plan. This triggered the initial sell off in PR bonds that accelerated with the taper tantrum, a bond market sell off in response to the Federal Reserve’s Quantitative Tightening (“QT”) campaign. Following these events, the Government Development Bank (“GDB”), made the untimely decision of going to market right in the middle of a global bond market seizure. This was exacerbated by the island’s constant liquidity needs due to massive operating deficits at every level of government and public corporations. Naturally, the curve catches fire with the Puerto Rico Power Authority (“PREPA”) bond issuance that was priced to yield 8%. The local curve began repricing off of the newly traded PREPA bonds and the dam breaks. This was a very big deal. Back then, PREPA traded above the General Obligation (“GO”) bonds, that is, it was perceived to be the strongest credit amongst Puerto Rico issuers, right after those issued by the Sales and Use Tax vehicle (“COFINA”). Levered longs, which were a combination of local mutual funds and local investors, were forced to liquidate into a very illiquid market. During early 2013, waiting lists for bond bids were already famous amongst PR residents. Now patience had run its course and the only source of liquidity was the tax exempt market. This market offered liquidity at least 20 points below marks (artificially propped up by the lack of trading, hence the infamous waiting lists)…. To clarify any misconceptions, these waiting lists were just a function of market participants unwillingness to recognize the real value of the bonds (the gap between tax exempt and taxable markets), thus the reluctance to sell at market prices created this backlog.

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Once the dust settled, the entire curve was yielding north of 12%, effectively shutting PR out of the bond market. Without market access to fund ever increasing fiscal deficits, the island hit a wall. Congress response was enacting the Puerto Rico Oversight, Management, and Economic Stability Act, commonly known as PROMESA, which was signed into law on June 30, 2016.

The primary purpose of PROMESA was to provide PR with a way to restructure its debt and establish a path towards fiscal stability.

Under PROMESA, a seven-member Financial Oversight and Management Board (“FOMB”) was established to oversee PR's finances and develop plans to restructure its debts. This board has the power to negotiate with creditors, enforce budgetary controls, and approve fiscal plans for the island's government agencies.

Additionally, PROMESA created a mechanism for PR to restructure its debts through a process similar to bankruptcy. This process, known as Title III, allowed the island to seek debt relief through the courts while protecting essential services and pensions.

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The act also included provisions to promote economic growth and investment in the island. Unfortunately, the Oversight Board solely focused on tackling the debt and fiscal spending during the last seven years. To be fair, PR was sidetracked by Hurricane Maria, a category 5 hurricane that caused havoc in 2017. As a consequence, major economic interruption ensued that lasted at least 6 months, costing tens of billions of losses, and took more than 3,000 souls. Nonetheless, there has been no significant progress nor perceived efforts from the FOMB to concurrently with the debt restructuring, advance investments and spur economic growth. The position of revitalization coordinator, created by the act has yet to be filled after it was left vacant in February of 2019th.

Under Title III, Puerto Rico has managed to cut its debt stack by a significant amount. As a result, annual debt service dropped from $4.2 Billion to $1.15 Billion. Tax supported debt, which only includes COFINA and the GO, was cut from $51 Billion to $20 Billion. Please bear in mind that PR residents do not pay federal taxes, so this is the only tax supported debt load, now standing at less than 20% of gross domestic product (“GDP”). Different from the Greek sovereign restructuring , PR only experienced a minor nominal GDP contraction at the onset of the crisis as shown in the graph below. While Greece suffered significant economic hardship during the restructuring, PR economic contraction had run its course.   Interestingly,Greece debt was barely cut and only minor adjustments were made.  Nonetheless, it trades at least 200bps lower than PR credits, while its debt load remains elevated at 175% debt to GDP vs themeaguer 20% debt to GDP of Puerto Rico post bankruptcy….

To the surprise of many, cash balances kept building up in government coffers during the title III process as tax collections kept creeping higher. Not a surprising development, if we look at the nominal GDP graphs and table on this page... 2018 and 2020 were hit by the Hurricane Maria disruption and Covid, respectively.

On a per capita basis the island has been making progress as well, as shown below...

Ironically, the debt was significantly reduced regardless of the positive data backdrop. Meanwhile, tax collections jumped by a staggering 50% from the onset of the bankruptcy process in 2015 to the fiscal year ending in 2023, driven by a nascent economic expansion and improved fiscalization by Hacienda. The main drivers of this expansion were a healthier banking system, tourism, and hurricane recovery efforts. The latter caused federal funds assigned to rebuild and strengthen island infrastructure. Efforts amount to almost 100% of GDP and are financed by federal funds. In the graph below this massive deleveraging is clearly depicted.

For a more granular look at the consistency of the rising tax collections, please see the table below. We are fans of tracking tax revenues as they show a better picture of the economic strength and momentum, rather than the economic data produced by the government.The latter, in our opinion, is glitchy, untimely and does not measure accurately the true state of the economy. Furthermore, the debt/credit strength is a function of the nominal economy and not of real economy. This is reflecting how tax collections greatly benefit from inflationary pressures.

Another data set that confirms this strength in tax collections is the labor market which has been gathering surprising strength as shown below…

Moving on to economic green shoots

Passenger traffic at the Luis Munoz Marin International Airport has been growing consistently since it was successfully privatized in 2012. In fact, June 2023 was the month with the most passengers ever recorded at the airport. Qualitatively, we believe the privatization of the airport was an inflection point for the island and marked,alongside the PR 22 Highway transaction, a shift towards privatization of poorly government run assets. These assets represented a significant drag on the government as most were subsidized by general fund revenues either directly or through the Government Development Bank. The pace of privatization has been slow, yet real progress has been made over the past decade. Recently the cruise ports have been added to this privatization list alongside transmission, distribution,and generation of electricity. In the following years, we expect to see more highway transactions, as well as other key infrastructure that can be optimized,such as the Aguadilla Airport and highway greenfield projects. In our opinion,PROMESA and the Title III experience will greatly hinder and obstruct market access for PR going forward. This will in turn, force the government to rely more and more on private operators and private projects for key infrastructure and essential services. Ironically this will strengthen the credit. For one,supply of new bonds will be greatly constrained while government reliance and funding are reduced. Structurally, we like to say, PR has cornered itself into fiscal discipline...

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Another economic green shoot

Local banks have never been stronger. During the early 2000s, the banks ran into difficulty due to the absence of section 936 funding. For those that haven't heard of the now defunct IRS tax code section 936, it was a tax incentive that allowed US multinational firms to repatriate, on a tax free basis, their earnings from activity held inPR. These firms generated enormous amounts of cash and some of it served as the foundation for a significant credit expansion that propelled the island economy from the 70s all the way into the late 90s, when 936 was repealed. As the tax incentive wound down, banks began losing deposits and had to turn to more unstable and relatively expensive funding sources such as brokered CDs. This funding instability brought a drought of credit that caused a severe real estate downturn along a lasting economic recession which morphed at the later stage, into our infamous sovereign crisis....

Fast forward to today, and banks are awash with core deposits. Loan books have been cleaned and as such there is a significant “ amount of dry powder” available for future loan growth.

Meanwhile profitability, which contributes to tax collections by the banking system, is running at all-time high for the sector... PR banks have no significant CRE exposure, let alone construction loan risk. The island has experienced a very long period of low construction activity which began with the aforementioned credit drought and extended until very recently. The islandis underbuilt in almost every segment of the real estate market. While bank shave barely begun re-staffing their construction lending departments....There is strong supporting data from the banking system to affirm the notion that the system has rebuilt itself into a very resilient one, which has become extremely efficient, more profitable and risk averse. Itis worth mentioning that core deposit franchises in PR are very strong, hence there is very low risk of deposit flight in the banks. The banking system will provide stability to the island by insulating it from exogenous factors, in the event that the global financial system comes under pressure due to mainland CREworries or other unforeseen black swans.

There are many other greenshoots, but the most overlooked one is the fact that the bankruptcy process is coming to an end. This title III process has cast a dark cloud over the economic prospect of the island. It has been a significant distraction, has drained excessive amounts of resources from the central government and has deterred investment and economic activity. As the island exits the bankruptcy process, government spending, although constrained for the lack of market access, won't be a drag on GDP. Infrastructure projects, funded by federal grants, are accelerating, while private sector construction spending improves alongwith the overall strength of the economy. There are various structural issues that still plague the economy. These are all “knowns” and what we have learned from experience is that known issues in PR tend to be resolved over time. The frustrating part is that it takes TIME, and lots of it, for issues to be fixed,unfortunately. Case in point is the privatization of PREPA. It is well known that PREPA was a significant obstacle for economic development. The high cost of electricity and reliability of the grid were “knowns” since the 90s. It took way too long and bankruptcy to finally put in place a structure that in our opinion will fix the rotten infrastructure. This process helped neutralized the entrenched labor unions that had appropriated the system for themselves rather than for the good of the people. Below we show some of the most important remaining“knowns” that need to be fixed for further economic development:

* Tax on inventories, high corporate tax, high income tax

* At will employment

* Permitting process

* Uniformity amongst municipal patents, taxes, regulations

* 78 municipalities should become just 5 counties

* Jones act, in particular for value added zones (ports, airports etc) ((This one is for the US Congress to take action,  as PR has no political/sovereign power to eliminate or modify the act))

These “knowns” make press almost every week. And in PR that is a good thing since its a sign that we are getting closer to resolution of these matters.

In conclusion, there is ample data, empirical evidence and qualitative factors that collude to paint a very constructive picture for the credit of Puerto Rico. It is a credit that in our opinion, hasbeen overly delivered. Hence, making it easily sustainable while enabling the government to accumulate significant cash reserves.  Below is the latest bank account update,published by the government, that shows an incredibly large amount of reserves that continues to build up.

This reserve is staggering insize. For context, the budget for the general fund for the fiscal year is$12.740 Billion (source: FOMB)

As reserves continue to build dueto economic upside surprises and inflationary pressures, PR bonds will becomes carcer. The absence of supply due to ample working capital reserves and an eventual market reckoning of conclusive positive fundamental factors will coincide to exert upward pressure in prices. These market forces should continue delivering strong absolute returns for Puerto Rico municipal bonds and even more so on a relative basis within the municipal bond market. Considering that PR bonds are triple tax exempt and the fact that the market is pricing the entire local curve from the perspective of a very risky and weak credit, we are convinced this is an opportune time to be constructive.  Furthermore, amidst the noise, over the past couple of years, the S&P Municipal Bond Puerto Rico Index has been performing extremely well, particularly on a relative basis to other municipal securities...we think this shall continues…

At X-Square we are always available to chat and discuss in further detail the PR credit complex as well as our newly launched ZTAX ETF, which seeks to monetize and take advantage of this high yield market opportunity. ZTAX will be paying its first dividend during July and quarterly thereafter… For more information, please visit our website www.x2etfs.com

Thank you,

X-Square Capital LLC