Description

We recommend buying bonds of Puerto Rico’s Government Development Bank (“GDB”) at the current dollar price of approximately $39.00.  We think this will be an attractive medium term hold but also believe it will be an excellent short-term event-driven IRR as it completes its restructuring under Title VI of PROMESA in a few months.  I think this is a particularly interesting VIC idea as, since these are municipal bonds, retail investors and small funds can also buy these bonds along with the larger distressed funds (generally at better prices than the larger institutional distressed investors if they have any prior relationships with muni dealers).  There is $3.8 billion face amount of debt with the below cusips (all pari):

Puerto Rico Background (very generally)

Before discussing GDB specifically, I want to first give some background on the general Puerto Rico debt debacle as I think it helps in understanding why this opportunity in GDB exists.  I think having a general understanding of all the issuers of Puerto Rico debt is important (which I won’t get into here) so I would encourage anyone interested to do additional reading. 

Puerto Rico has over $70 billion in face amount of debt across about 20 issuers.  The Commonwealth itself with its General Obligation (“GO”) and Commonwealth guaranteed bonds makes up about $18 billion of this amount.  GO bonds are the typical source of financing for states and municipalities and are backed by the full taxing authority of the government.  The Puerto Rican Constitution (and I assume other states and possibly even federal laws) limits the amount of GO debt that can be issued based on financial parameters, mostly related to tax revenues – the general market and rating agencies provide a limit as well.  Puerto Rico’s triple tax-exempt status for all Americans allowed it to be highly leveraged at attractive rates compared to other states, but the fact that it has had consistent population and GDP declines since 2006 has made the situation far worse.  Rather than taking measures to try to balance the budget, Puerto Rico simply got creative in terms of financing sources to fund budget deficits.  The most notable way being its creation of the Puerto Rico Sales Tax Financing Corp. (known by its Spanish acronym COFINA) in 2006.  COFINA is simply a legal entity that collects 6% of the 11.5% general sales and use (“SUT”) tax in Puerto Rico, but since it is its own legal entity with a segregated bank account, it is considered a revenue bond and is not subject to the debt limitations of the constitution on GO bonds.  COFINA has now issued more debt than the commonwealth itself with nearly $19 billion of COFINA bonds.  Puerto Rico has securitized many other revenues streams, many of which were once tax revenues flowing into the general fund for GO and island essential services.  Puerto Rico had approximately $43 billion of debt in 2006 compared to the current ~$73 billion today (not including accrued interest).    

PROMESA

I began following the Puerto Rico situation as it began getting topical in the distressed world around 2013.   The island was able to kick the can in early 2014 with the largest ever municipal bond offering of $3.5 billion of 8% GOs issued at 93.  This only lasted two years until the governor (at that time) enacted an emergency moratorium on all bond payments in early 2016.   There were many attempts leading up to this moratorium and following it at consensual restructurings for the Commonwealth debt and many of its instrumentalities but all were unsuccessful.  The federal government then stepped in creating a bankruptcy law for Puerto Rico (as a territory rather than a state, Puerto Rico could not use the U.S. Bankruptcy Code, specifically Chapter 9 for U.S. municipalities) called the Puerto Rico Oversight, Management, and Economic Stability Act, or PROMESA.    

PROMESA offers two methods of restructuring: Title III and Title VI.  Title III is very similar to Chapter 9 of the U.S. bankruptcy code and is the path for most of the Puerto Rican debt including the Commonwealth, COFINA, HTA, ERS, and PREPA.  GDB, however, is effectuating its restructuring via Title VI which I would describe as a combination between a prepackaged Chapter 11 process and a consensual out-of-court restructuring.  I think this is a significant advantage of the GDB as it lowers the process risk substantially.

When I first began looking at investing in Puerto Rico seriously, shortly before PROMESA was passed, I thought the GO bonds were the only “investable” bonds in the stack.  Basically, I thought the GOs were the only bonds which couldn’t simply be “wiped-out” (as Trump later quipped) by the government.  The stated goal of the entire restructuring is to allow Puerto Rico access to the capital markets, and considering GO debt is the principal source of financing for municipalities, the logic was that they would want to treat GO bondholders fairly since the Commonwealth/GO would be the only future issuer of debt.  While I have not even described the GDB yet, I viewed it on the other end of the spectrum.  GDB had been an effectively defunct entity since losing its IG rating in 2014 and officially began an orderly wind-down a few years later, thus I initially thought the GDB bonds would be some of the last bonds to receive an adequate recovery.  While these are all distinct legal entities, they are effectively all supported by tax revenues (even the price of power, for example, since it is a monopoly controlled by the government, could potentially be viewed as a source of tax revenues since a required lower price for power could allow residents to pay higher taxes elsewhere) so I believed the Commonwealth would be able to effectively create whatever recovery they wanted to for any specific instrumentality.     

Since I’m suggesting you buy the GDB bonds, I have obviously changed my view on this.  While that view is easy to say, it is far too simple to describe what actually happens in reality.  What often happens in large and complex restructurings is that momentum builds in directions that have the least resistance.  While I think it makes some intuitive sense that the GOs should receive the best recovery, their assets (the taxing power of the government beyond essential services) is the most difficult to isolate and quantify.  This creates a huge barrier to completing a restructuring.  The GDB on the other hand, which I will go into next, will likely be the first Puerto Rican entity to complete a restructuring and will be model for many of the other smaller instrumentalities.

The Government Development Bank for Puerto Rico

As its name describes, the GDB was the bank, or liquidity management entity, for the Commonwealth of Puerto Rico.  GDB was created in 1942 with the goal of helping to finance Puerto Rico’s economic infrastructure projects and to act as fiscal agent and financial advisor to Puerto Rico and its instrumentalities. Over time, GDB’s role evolved such that it became significantly intertwined in the daily functioning of the Puerto Rican government.  With the Commonwealth’s implicit support, the GDB was a very effective tool as it had a very low cost of financing to make loans to the Commonwealth, its Agencies, Municipalities, and Public Corporations.  With the economic backdrop in Puerto Rico deteriorating and the GDB being required to help fund deficits, the risk profile of the GDB increased substantially.  Once it lost its investment grade rating in 2014, its role as the island’s low cost financier ended.  As many of its assets became non-performing, the GDB lost its ability to refinance its debts and defaulted on its $360 million bullet bond on May 1, 2016.

At this point in time, as I alluded to above, investors (particularly myself) had a very negative view on the GDB.  Not only was it unclear how many of its assets, which are loans to other government entities, would be treated, the liabilities were also very daunting.  Aside from the $3.8 billion of bonds, there were also ~$3.5 billion of deposits, and from my vantage point (not being a party to any of the negotiations), it was unclear how these deposits would be treated. 

Fast forward to today and most of the uncertainties are gone.  There is a Restructuring Support Agreement in place, a fiscal plan representative of the RSA approved by the PROMESA Oversight Board and other requisite parties, and legislation in place allowing the restructuring to be done via Title VI.

The Restructuring Support Agreement

There have been restructuring proposals floated between the GDB and creditor groups going back to 2015 (maybe even before that).  The major breakthrough came when the AAFAF, GDB, and a majority of the bondholders agreed to an RSA, effective May 17, 2017.  In July, the Oversight Board approved the plan to allow a restructuring under Title VI of PROMESA and the “GDB Restructuring Act” was enacted in August.   

The major source of recovery for the GDB bondholders and other creditors are loans to the 78 municipalities, which have remained current thus far, so when Hurricanes Irma and Maria hit Puerto Rico, it put substantial financial strain on these municipalities.  The original RSA was extended a couple times and in March 2018, a new simplified RSA was agreed to. 

In both cases, the GDB was to divided into a “good bank / bad bank” structure.  Generally speaking, the deposits associated with government mandated defunct loans are to be transferred to a Public Entity Trust and the rest of the liabilities (the bonds and municipal deposits) along with most of the assets are to be transferred to a Recovery Authority.  In the first RSA only a portion of the municipal deposits were set-off against corresponding loans while in the current RSA, all deposits have been set-off against corresponding loans (providing substantial payment relief to the municipalities).  This, so it seems, has resolved the complaints some of the municipalities raised with the original RSA.

If you are only going to read three things associated with the GDB it should be its latest fiscal plan and both RSAs (the May 2017 and March 2018).

Recovery

The RSA outlines all of the assets and liabilities of both the PET and the Recovery Authority.  The Recovery Authority will effectively receive the proceeds on $5.6 billion of loans and $85 million of real estate.  The total liabilities, including ~$400 million of accrued interest on the bonds and $456 million of deposits to be treated pari with the bonds, are $4.6 billion.  This entire $4.6 billion will be exchanged into a single bond at 55c on the dollar, or new bonds of $2.5 billion.

I have assumed zero recovery on any of the loans for which I don’t have an educated guess on recovery and believe I am being conservative on the other assets.  Below is what I think the recovery value is:

The bonds trade flat and generally have about 10 pts of accrued (you should check how much accrued exists in the bonds before deciding on a price to pay) so this $2.0 billion of recovery value results in a recovery of 43.8 on your claim, or a bond equivalent (on the face amount of the bond which is how it trades) of 48.4.  So this is greater than a 20% return on a purchase price of 39.0 which I think will occur once the restructuring is completed.  Again, I would point out that I think I am being conservative on the recovery of just the $2.6 billion of face amount of assets above and am assuming zero recovery on $3.1 billion of other assets.  Just a few cents of recovery on those loans results in additional points of recovery for the GDB bonds, which is a meaningful percentage on 39c of cost.  The 48.4 recovery on the face amount of the bonds is equivalent to the new bond trading at just under 80c on the dollar.

Lastly, I think the technicals of this situation are very favorable.  Currently the largest cusip is $541 million so having a new single liquid current-pay bond which is rapidly paying down principal I think will increase the demand  for the paper.  Also, most of the cash will be distributed to claimholders upon effectiveness which will result in approximately 9c on the face of the bonds coming back to you (you pay 39c today and should receive ~25% of your cost back in a few months).  The municipal loan portfolio amortizes quickly and there is a FCF sweep which will pay down the take-back paper which I think will help pull the price to par.

I admittedly have not gone into much detail about how I arrive at my recovery but I wrote this idea how I personally would like to receive the information were I on the other side (and it is already longer than what I had wanted).  I think going through the information yourself is important and you should come to your own conclusions on valuation – I’m happy to answer any questions in the comments.  For me, understanding the background of how we got here and what the important things to focus on is a huge time-saver which is all I am trying to do for anyone interested.

Catalyst

Effective date of the Title VI restructuring