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Must-know: An update on Puerto Rico’s economic and fiscal issues

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An update on Puerto Rico’s economic and fiscal issues

“The recent downgrading of Puerto Rico’s public debt to non-investment grade was a clear signal that the current fiscal situation poses serious risks to the island’s economic future,” said Dr. William Dudley. Dr Dudley is the New York Fed chief. In a speech to the Certified Public Accountants of Puerto Rico, in San Juan, on June 24, Dr. Dudley discussed the economic and fiscal issues facing Puerto Rico’s economy and the initiatives that could be taken to improve the island’s situation. He has also commissioned a new report to analyze Puerto Rico’s economy. It’s an update on the report published by the New York Fed in 2012.

Implications for Puerto Rico debt

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Puerto Rico has been in the spotlight recently due to the downgrade of its debt to junk status in February, 2014, by all three major credit ratings agencies (Standard & Poor’s, Moody’s, and Fitch). Municipal debt (PZA) issued by the island is free from state, local, and federal taxes. Due to this triple advantage, a significant number of individuals, institutional investors, and municipal bond ETFs (MUB) were holding debt issued by the Commonwealth of Puerto Rico, estimated at about $70 billion. A debt default by Puerto Rico would have repercussions on the $3.7 billion municipal bond market.

Total municipal debt outstanding was estimated at about $3.7 billion at the end of 1Q14, making up about 9% of the total outstanding debt in the U.S. Individual investors held most of the total outstanding municipal debt at about 44% of the total. Banking institutions like some of the firms included in the SPDR Financial Select Sector ETF (XLF) held about 12.4% of the total municipal debt outstanding.

Recent events in Puerto Rico affect the municipal bond market

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Unlike most states in mainland U.S., the financials of public corporations (for example—utility companies) are included in the government’s balance sheet. These corporations have issued significant amounts of debt in recent years. The government of Puerto Rico has recently announced plans to undertake the restructuring of the debt burden of some public corporations—a step that may be needed to solve the island’s fiscal and economic issues.

In this series, we’ll discuss the key elements of Dr. Dudley’s speech on the situation in Puerto Rico. We’ll also discuss why municipal debt has outperformed returns on other asset classes, like stocks (IVV) and other forms of investment-grade debt (BND) and Treasuries (TLT).

About Dr. William Dudley

Dr. William Dudley took over as the tenth head of the New York Fed in January, 2009. Prior to his appointment, he was Executive Vice-President of the Markets Group at the New York Fed, which manages the System Open Market Account (or SOMA). As head of the New York Fed, he is also Vice-Chairman and a permanent member of the Federal Open Market Committee (or FOMC), which formulates U.S. monetary policy. Dr. Dudley is Vice-Chairman of the Economic Club of New York. He has also been the Chairman of the Committee on the Global Financial System of the Bank for International Settlements since 2012. A former partner and Managing Director at investment management firm Goldman Sachs, Dr. Dudley has a doctorate from the University of California at Berkeley.

The purview of the New York Fed extends over the Second Federal Reserve District. The district includes the State of New York, the 12 northern counties of New Jersey, Fairfield County in Connecticut, Puerto Rico, and the U.S. Virgin Islands. The New York Fed is the largest of the 12 Federal Reserve Banks (or FRBs) in terms of assets and volume of activity. Besides the normal functions common to all the FRBs of the 12 districts, the New York Fed also has some unique responsibilities, including conducting open market operations on behalf of the U.S. Federal Reserve, intervening in foreign exchange markets, and storing monetary gold for foreign central banks (Source: New York Fed).

In the next section, we’ll cover aspects of Dr. Dudley’s speech that discussed the key issues facing Puerto Rico’s economy.

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