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Puerto Rico Insured — Third-quarter 2016 review

Shaun Burgess is aportfolio manager and fixed income analyst at Cumberland Advisors. The viewsand opinions expressed in this piece represent only those of the author and arenot necessarily those of S&P Global Market Intelligence.

Puerto Rico started off the third quarter with a bang: ahistoric default and a seminal moment in the drama that has played out over thepast two years plus on the little island in the Caribbean. Cumberland'sexpectations of default were met in dramatic fashion, but so was our long-standingpresumption that the federal government would intervene. We did not expect thegovernment would allow 3 million American citizens to wallow in limbo, evenwith the staggering degree of dysfunction displayed by our electedrepresentatives. Our strategy, however, did not rely on that outcome. As DavidKotok likes to say, "Hope is not a strategy." Our trust has alwaysbeen in the insurers we use, and they have so far not disappointed in living upto their obligations to pay principal and interest when due. This has been, andremains, the cornerstone of our Puerto Rico Insured strategy. The details ofthe commonwealth's default can be found in our previous commentary"Puerto Rico — The daysafter."

Of greater importance to the narrative has been the federalgovernment, which, in a rare moment of bipartisan cooperation, passed ThePuerto Rico Oversight, Management and Economic Stability Act (PROMESA).President Barack Obama signed the legislation June 30, hours before the islandexperienced its largest default to date, including the nonpayment of thecommonwealth's constitutionally backed debt. PROMESA establishes a federalcontrol board to oversee the island's finances and spending, and it also hasthe power to restructure Puerto Rico's existing debts through court proceedingsif consensual negotiations fail. It also provides a stay on litigation, whichhas been enforced in multiple suits in the months following PROMESA'senactment. Establishment of PROMESA was a turning point for the island andwill, we hope, right a ship that has been crippled through decades ofborrowing, overspending and mismanagement.

Defaults continued across differing authorities in Augustand September, though these amounts have been much smaller and far lessconsequential. We expect defaults to persist and uninsured bondholders to feelpain as bonds trade flat and restructuring negotiations commence. Outstandingand stayed litigations are stories that have yet to play out. Ultimateresolutions are up to the courts to decide. Their outcomes remain questionablein light of the powers afforded by PROMESA.

August saw President Obama fill the federal control boardwith the participants below, whose positions are also listed. Many observers,including Cumberland Advisors, are pleased with the bipartisan mix ofindividuals and their qualifications. Make no mistake: these folks have adaunting task in front of them. It will be many months before they have wadedthrough the island's murky finances and adequately understood the scope of theisland's various credit structures and overlying claims. The oversight boardhas until Sept. 30 to select a chairperson, who will then select an executivedirector.

Andrew Biggs — Resident scholar atthe American Enterprise Institute

Jose Carrion III — President andprincipal partner of HUB International CLC, LLC

Carlos Garcia — CEO of BayBostonManagers LLC and managing partner of BayBoston Capital LP

Arthur Gonzalez — Senior fellow atNew York University School of Law and previously an adjunct professor at NYU

Jose Gonzales — CEO and presidentof Federal Home Loan Bank of New York

Ana Matosantos — President ofMatosantos Consulting

David Skeel Jr. — The S. SamuelArsht professor of corporate law at the University of Pennsylvania Law School

We continue to await the conclusion to the restructuring ofthe Puerto Rico Electric Power Authority (PREPA). The requisite rate increaseshave been approved. The process is now with the rating services to review thespecial-purpose vehicle known as the Corporation for PREPA's Revitalization(CPR). Expectations are for an early 2017 issuance of $7.8 billion in exchangebonds.

Uncertainties and unknowns remain, with eventual recoveryvalues yet to be determined. However, we expect bondholders to fare better atthe hands of a federal control board than they would have with Gov. AlejandroGarcía Padilla, who has been hostile to debtors. His questionably legalmoratorium law, voluntary nonpayment of debt, and transfer of debt paymentsaway from bondholders are a few examples of choices that validate our opinionof him.

Market response to restructuring events has been positive,with both uninsured and insured debt trading higher. Insured debt has seensignificant gains with the insurers' payments of principal and interest afterthe commonwealth's July 1 default, and it now trades at yields not seen sincethe inception of our Puerto Rico strategy. The fulfillment of insurerobligations was expected and came as no surprise. Our work regarding theinsurers has been paramount to the success of our strategy. We expect theinsurers we use to continue to fulfill their obligations and leverage theircapabilities and expertise in future restructuring negotiations.

Cumberland Advisors manages approximately $141 million inits Puerto Rico Insured strategy. We started the style in March 2014 withinsured paper yielding between 6.5% and 7%. With yields now at 4%, and lowerfor many callable bonds, we believe the value proposition remains attractive.Following the full payment of insured obligations, we have started to include asmall allocation to carefully selected insured Puerto Rico bonds in bothtax-free and taxable accounts outside of the strategy. We do so only withAssured Guaranty debt, which carries a rating of A2 by Moody's and AA byStandard and Poor's.

Cumberland Advisors' Puerto Rico Insured strategy does notinclude uninsured debt from any island authority but focuses instead on theheadline-driven opportunity in carefully selected insured debt. It is criticalto examine the details of each bond indenture and the terms of each insurancecontract. Blindly buying insured bonds is not a strategy we recommend.