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Financial Times

Puerto Rico Struggles With Debt Burden


18 May 2005
Copyright © 2005 The Financial Times Limited. All rights reserved.

"Doing nothing is not an option," said Anibal Acevedo-Vila, governor of Puerto Rico, when he visited New York last week to talk to municipal bond investors about the struggling island's finances.

Municipal bonds, or "munis", are debt - largely tax-free to investors - that is issued by individual states and entities to fund development. Puerto Rico, a commonwealth of the US, is one of the largest single issuers of the bonds.

Mr Acevedo-Vila was sworn in early this year after a tight election and a court battle. He faces a struggle to develop Puerto Rico's economy while cutting the Dollars 1.3bn structural deficit. In March, he submitted a budget proposal to reduce the public sector. But he faces a legislature controlled by the opposition.

"Since everyone recognises the deficit is a problem, I don't see how they don't at least come up with alternatives. If they do that, I'll consider them," he told the Financial Times.

Puerto Rico bears a heavy debt burden. According to a recent report by Moody's Investors Service, the island's net tax-supported debt per capita is Dollars 6,812 - almost twice the nearest state, Connecticut, at Dollars 3,614. As a percentage of personal income, that debt is equivalent to 56.7 per cent, compared with 11.1 per cent for Hawaii, the worst of the states.

Currently, the island's general obligation bonds - those backed by the "full faith and credit" of the government - are rated Baa1 with a negative outlook by Moody's and A- with a negative outlook by Standard & Poor's. These are among the lower ratings held by individual states, many of which are AA-rated.

During the 2004 fiscal year, Puerto Rican entities sold Dollars 7.6bn worth of bonds. Of that, Dollars 4.24bn consisted of new funds and Dollars 3.36bn in refundings.

This year, Puerto Rico plans to issue about Dollars 575m in fresh GO bonds, plus issues from various entities including the Convention Centre authority, a first-time issuer. Unlike US states, all island muni issuance is controlled by the Government Development Bank, which times the issues carefully to avoid swamping the market.

There are some 15,000 issuers in the wider Dollars 2,000bn muni market. Many gear their sales towards local retail customers, or "mom and pop" investors, who buy and hold the bonds to maturity to take advantage of their tax-free status.

The size of Puerto Rico's outstanding debt, however, and the resulting active market have helped the island's bonds maintain tight spreads relative to their credit rating.

Puerto Rico is by far the largest and best-known of the entities enjoying commonwealth status and investors like the diversification achieved by holding the paper. In addition, the commonwealth status means the bonds enjoy a "triple whammy": they are free of federal income taxes for mainland investors as well as exempt from state and local income taxes.

"You're always going to get demand for triple-tax exempt paper and the fact that it's actively traded gives people comfort in holding it," said Scott Smith, municipal bond portfolio manager at Lord Abbett, which manages approximately Dollars 5bn in muni investments. "There's an established trading range and you can have a fairly good idea what the bonds are worth at any time."

Lower-rated, but consequently higher-yielding, paper is also in demand at the moment.

Owing to the lack of transparency in the market and the buy-and-hold nature of many investors, muni bond moves are usually less dramatic than other bonds.

For example, they have been largely unaffected by the recent worries about GM and Ford, which have hit many corporate bonds and boosted Treasuries.

"Welcome to the low-yield world - it is really hard to find spread right now," said John Flahive, director of fixed-income strategies at the private wealth management group of Mellon, the Boston-based financial services group.

"Overall supply continues to be light compared with demand and there is also a sense of complacency that even in the worst circumstances, munis seem to pay off, so why should investors overreact?"

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