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Puerto Rico Insured: Fourth Quarter 2016 Review

Shaun Burgess is a portfolio manager and fixed income analyst at Cumberland Advisors. The views and opinions expressed in this piece represent only those of the author and are not necessarily those of S&P Global Market Intelligence.

All Quiet in the Caribbean

As the fourth quarter comes to a close, we reflect on the events of the last year and look to the future. July became a pivotal point for Puerto Rico as the island experienced its largest default to date, which included, for the first time, obligations guaranteed by the commonwealth. This was a seminal moment in Puerto Rico's story, as the constitutional guarantee was seen by many as sacrosanct. Puerto Rico has proven, to bondholders' dismay, that guarantees and promises are only as good as the conviction of those charged with enforcing them. July also saw the passage of the Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA). We highlighted the default and PROMESA in our prior quarterly commentary, "Puerto Rico Insured — Third-quarter 2016 review."

Election activity was not limited to the U.S. mainland. November saw Ricardo Rosselló of the New Progressive Party elected governor of the Commonwealth of Puerto Rico. Mr. Rosselló seems capable and has accepted the task before him with fervor. He is seen by many as favorable to bondholders and as having an understanding of the importance of access to debt markets for Puerto Rico. He is also a supporter of statehood for the commonwealth and has voiced his commitment to promoting that position.

The fourth quarter has been quiet as we head into the holidays and the close of 2016.

It will take time for the PROMESA-created Fiscal Control Board to get their feet underneath them and to sort out the complexities of the task before them. Although they have made some progress, substantive changes aren't expected until at least the first half of 2017 or possibly later, depending on negotiations and litigation. The control board has announced it will start good-faith negotiations with creditors this week. Given the control board's estimate that the commonwealth will face a deficit of $67.5 billion over the next 10 years, haircuts should be expected across all authority debt.

The commonwealth and related entities have now defaulted on approximately $1.02 billion of principal. General-obligation debt is the largest fraction of this total, followed by obligations of the Governmental Development Bank. Our expectation is for this default trend to continue as we move into 2017. We also expect the insurers, Assured Guaranteed Municipal and National Public Finance Guarantee, to continue to make all principal and interest payments, as they did following the July 1 default.

A number of lawsuits have been stayed under PROMESA, but a more interesting fight has arisen. For the first time, general-obligation bondholders are testing the segregation of sales tax revenues in court. Sales tax revenues backing Puerto Rico Sales Tax Financing Corp. (COFINA) debt are securitized and segregated from what are termed "available resources." Only after sufficient debt service has been transferred to the trustee are revenues then available to the commonwealth. COFINA has existed for years and is backed by numerous legal opinions validating its legitimacy, although decisions put into the hands of the courts can often be surprising. We expect that negotiations may eventually lead to some impairment to COFINA bondholders.

We continue to wait for the Puerto Rico Electric Power Authority's ultimate restructuring. The requisite rate increases have been approved. The process is now with the rating services to review the special-purpose vehicle known as the Corporation for PREPA's Revitalization. Expectations are for an early 2017 issuance of exchange bonds.

The municipal market has seen a vicious sell-off following the election of Donald Trump, as John Mousseau, Cumberland's Director of Fixed Income, has documented in his quarterly commentary, "Tax-Free Municipal Bonds: Fourth-Quarter 2016 Review." Insured Puerto Rico was not immune and has traded in sympathy with the rest of the municipal market. Yield spreads between insured Puerto Rico and similarly insured paper have tightened as a result. We still think insured Puerto Rico offers terrific value at yields of 4.75% or better.

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