Puerto Rico is a small island with a population of 3.7 million people and a municipal debt load of $104 billion. Only Florida, Illinois, New Jersey, New York, Ohio, Pennsylvania and Texas – states that are all substantially larger – have more debt outstanding. Puerto Rico’s government has been financing its deficits with bond issuance, although it recently vowed to put an end to this practice in 2014. The island’s economy has been contracting for several years, but recently it began to move slowly toward positive growth. Puerto Rico’s labor market is similarly weak, with an unemployment rate of 15 percent, nearly double the national rate of 8.1 percent.

In short, Puerto Rico’s debt-to-GDP load and unemployment rate are greater than those of any state in the country. It’s on a knife’s edge, and it’s easy to imagine several black swans that could precipitate real fiscal distress.

Puerto Rico’s bonds enjoy some special qualities that keep demand for it at high levels. The island’s municipal debt enjoys a triple-tax-free exemption across the country, meaning that investors in any state do not have to pay federal, state or local taxes on it. Wealthy bondholders in high-income tax states like New York and California can earn more yield by purchasing tax-exempt Puerto Rican debt than they could if they purchased the bonds of other states. Moreover, many municipal-bond single-state mutual funds are able to take advantage of this tax-exempt status and invest in Puerto Rico’s bonds. For instance, a mutual fund that is nominally invested only in California bonds is allowed to own Puerto Rico bonds as well, but not bonds from Texas or New York.

Despite being widely held, Puerto Rico’s bonds rank near the bottom of the investment grade scale, and there are a lot of opinions about how risky they are. A new bond investing website, Learn Bonds, recently interviewed two big mutual fund managers with opposing views on the island’s debt. Marc Prosser from Learn Bonds first interviewed BlackRock’s Peter Hayes:

Peter thought the credit risk on many PR bonds outweighed the benefits of extra yield. One of the concerns he has with Puerto Rico is that the economy is not diversified and focused heavily on tourism.

Prosser then interviewed Rochester Funds’ Scott Cottier, who oversees that firm’s municipal-bond mutual fund division. Cottier believes that Puerto Rico’s debt is a good investment because its government is reducing spending and increasing revenues; because pension liabilities have flatlined; and, most important, because the federal government would step in to backstop its debt if it were to default.

In a March commentary, Breckinridge Capital Advisors, an institutional and private-client fixed-income portfolio management firm, identified a number of trigger events that could possibly cause Puerto Rico to default:

• Ratings downgrade
• Elimination of the tax exemption
• Mutual fund redemption from rising interest rates
• Federal government cuts to Puerto Rico’s transfer payments

Breckinridge did not include an economic slowdown on its list, but I think with Puerto Rico’s high level of leverage it should be included. Breckinridge sums it up:

Although the threat is not imminent and the risk remains slim, Breckinridge believes the possibility of a default by Puerto Rico is sufficient to warrant the attention of municipal investors.

A Puerto Rico default would have negative market implications. High grade investors should understand the Commonwealth’s fiscal problems because a default might trigger mutual fund redemptions and bouts of illiquidity.

However, Puerto Rico’s debt situation is unique and unparalleled in the United States. A debt crisis in Puerto Rico will have limited impact – if any – on the extremely remote likelihood of a U.S. state default.

If Puerto Rico’s economy picks up, its government can patch the holes in its budget. But if the U.S. economy slides into recession again, Puerto Rico will be hit especially hard. The question bondholders are asking is whether they are getting adequately paid for the risk that a black swan event might occur.

GovTech interviews some state and city chief information officers about their use of Twitter, Facebook, Foursquare and YouTube to change how government operates and interacts with citizens.

Good Links

NPR: 50 years of government spending, in one graph

Reuters: State income up in April, but may not be enough

Standard & Poor’s: California’s bigger fiscal-year 2013 budget gap increases pressure to adopt austerity

LA Times: Fitch on new California budget problems: Don’t panic

Reuters: State of California estimates $2.1 billion in tax revenue from Facebook IPO

Bloomberg: New Jersey April revenue collections 5.3 percent below budget goals

Bond Buyer: Chicago to market $600 million in bonds

Bond Buyer: Municipal bond fund purchases carry risk

@Twitter Talk

Geithner: we can’t run the country on the assumption countries will have confidence in the US. #fiscalsummit

— Jen DePaul (@BondBuyerJen) May 15, 2012

RT @pewstates: #Stateline: Last weekend 236,000 people in eight states lost #unemployment benefits ow.ly/aVb3A — Pew Trusts (@pewtrusts) May 15, 2012

Surprise! States w/out income tax have higher sales and property tax ow.ly/aTq2C

— OK

Policy(@OKPolicy) May 15, 2012

A bet bad on risky casinos by the pension fund for Texas’s teachers: dallasnews.com/investigations…

— Michael Cooper (@coopnytimes) May 15, 2012

…despite media focus on state/local fiscal pressures still no broader trend of cities/localities defaulting/using reserves/insurance

— Muni Market Advisors (@Muni_Mkt_Advis) May 15, 2012

In a YouTube address released last Friday, California Governor Jerry Brown shocked his constituents with an announcement that the state’s projected revenue shortfall had increased to $16 billion. This followed very weak April state income tax collections, which deepened the budget hole from the $9 billion that Brown had originally forecast in January. The new deficit is a result of a reduced revenue outlook for California, higher school funding costs, and decisions by the federal government and courts to block certain budget cuts. New cuts that Brown floated yesterday will reduce General Fund spending as a share of California’s economy to its lowest level since 1972‑73.

The $92 billion budget that Brown had proposed in January for the fiscal year 2012-2013 (which starts on July 1) looked like this:

With the new revenue shortfall, almost every area of the state budget has been targeted for cuts; education, which accounts for 53 percent of General Fund spending, is the only category that was spared. In his revised proposal, Brown substantially increased K‑14 spending (i.e., includes two years of community college or vocational training) and protected the University of California and California State University from further, deeper cuts. School spending is mandated by Proposition 98, which requires that California pass through a substantial portion of state revenues to local governments to fund education.

Overall, Brown proposed that half of the budget hole should be plugged with spending cuts, 35 percent with tax hikes and 15 percent with financial gimmicks. Brown’s preferred budget cuts (pages 5-7) total $8.3 billion and include a $1.2 billion reduction to California’s medicaid program (Medi-Cal), an $880 million reduction to welfare (Temporary Assistance to Needy Families payments) and a 7 percent reduction in hours to in-home supportive-care-services providers.

These monies are the lifeline that millions of Californians rely on. It’s hard to get a sense of the human side of this, but it’s enormous. And without additional revenues, deeper cuts will be required.

Reuters’ Jim Christie picks up the story here:

In California, where local property taxes are limited by law, and local services, including schools, are thus largely funded by the state, the most important source of government revenue by far is personal income taxes. Capital gains income from the state’s wealthy residents helps fill the state’s coffers in good times, but falls sharply in bad times.

California’s larger-than-expected deficit did not faze traders in the $3.7 trillion U.S. municipal debt market, said Gary Pollack, managing director at Deutsche Bank Private Wealth Management in New York.

“The market is taking it in stride for the time being,” he said.

California bonds have been trading a little better over the last few weeks, aided by rising prices and falling yields in the overall municipal market, Pollack said.

California, the muni market’s biggest borrower, has about $80 billion in outstanding obligation debt, compared with its $1.9 trillion in economic output.

California has about $10 billion in borrowing capacity available, but it must balance its budget. The state continues to suffer from the aftermath of the financial crisis and real estate bust. At the same time, demands on the state have increased while resources have shrunk. There are dark clouds in the Golden State, and they are not likely to pass soon.

The Tax Foundation brings us a map showing that certain states have had much stronger increases in their percentage of wealthy taxpayers than others. North Dakota takes the top spot and is followed by other energy-rich states.

Good Links

St. Louis Fed: Map of failed banks – 2007 to present

Congressman Tom Reed: The Municipal Bond Market Support Act of 2012

Learn Bonds: The safety of state bonds: A historical perspective

The Times-Picayune: Louisiana is the world’s prison capital

Bond Buyer: Missouri nixes tolls on I-70

NYT: New York City Council to vet depository banks for social responsibility

WSJ: New York City explores privatizing its parking meters

@Twitter Talk

39 of 42 states allow for public employee retirees to receive a #pension check + work part time. Good or bad? bit.ly/JAVuj0

— Pension Dialog (@PensionDialog) May 14, 2012

Illinois law shifts more of funding burden for retiree health care to recipients bit.ly/IUE665 Could reduce OPEB liability by $9B.

— Bond Girl (@munilass) May 14, 2012

… Check out NFMA’s Intro to Municipal Bond Credit Analysis – and other upcoming industry conferences tinyurl.com/2dsptds

— MuniNetGuide (@MuniNetGuide) May 11, 2012

How a city of 65,000 in #Florida relies on only 9 employees. Read about the benefits: bit.ly/L0CYOy #labor

— GOVERNING (@GOVERNING) May 14, 2012

A quick look at the public projects of America’s smartest city, Palo Alto, California, which has soft-launched a new city website that uses social media. This is how America reinvents itself.

Good Links

House Ways and Means Committee: A hearing to examine oversight of tax-exempt organizations

Reuters: Three former GE affiliate executives convicted of fraud

Reuters: Brown pushes tax hike as California’s money woes deepen

MSNBC: Double-dipping: Staffer gets $89,000 pension while serving in N.J. governor’s office

Dayton Daily News: Dayton police and firefighters have higher rates of disability retirements

Bloomberg: Harrisburg ex-mayor left Pennsylvania’s capital nearly bankrupt

Bond Buyer: SEC Delays Action on MSRB’s Broker’s Brokers Rules

Bloomberg: Buying gone wild in muniland

@Twitter Talk

Read working paper on forecasting national recessions using state level data bit.ly/Jhfj20 — St. Louis Fed (@stlouisfed) May 11, 2012

Does fairness mean that everyone gets (1) the same, (2) what they deserve, or (3) what they need? ow.ly/aQwG9

— Psychology Today (@PsychToday) May 11, 2012

To date, FY11 data indicate natural boomer increase in number of public sector retirees and no mass exodus due to state #pension reforms

— Pension Dialog (@PensionDialog) May 11, 2012

When was the last time so many in #muniland were this bullish? blogs.barrons.com/incomeinvestin…

— Bob Nelson (@BNels22) May 14, 2012

California has a $16bln initial budget gap. GO Spreads are +72bps in 10yr range. Performance could suffer with a mean reversion (+90.7bps.)

— Daniel Berger (@munimarketmaven) May 14, 2012

If Cal got focused, cd b th center of th emerging Pacific world RT @nytjim: Shortfall in Cal’s Budget Swells t $16bn nyti.ms/JC7Cyb

— Nigel Cameron (@nigelcameron) May 13, 2012

General William Lynch, the newly nominated Receiver for the City of HBG, takes questions from the press: roxburynews.com/comments_displ… — Roxbury News (@RoxburyNews) May 11, 2012

The fees Harrisburg received for guaranteeing the incinerator debt corresponded to amounts needed to fill budget gaps. Pure insanity.

— Bond Girl (@munilass) May 14, 2012

I’ve previously featured a guest post about the advantage to retail investors of buying municipal bond mutual funds. Retail investors can also directly buy individual municipal bonds. This is a tiny part of muniland, but I could see it growing in the future. Today, I welcome a guest post from Andrew Wels, the head of retail fixed income and vice-president for retail at E*Trade Securities. Wels writes about the advantage of buying individual bonds and “laddering” them.

Buying individual bonds
by Andrew Wels

Most financial professionals would agree that a mix of stocks and bonds is essential to a well diversified portfolio. Stocks provide growth potential, and bonds offer both regular income and return of principal upon maturity. Many individual investors are familiar with selecting stocks, but bond investing tends to be viewed as more complex.

Bond funds vs. bond ladders

A bond fund, an investment in a portfolio of individual bonds, is a popular investment vehicle for accessing the fixed-income markets. Bond funds offer diversification and some characteristics of the underlying individual bonds in which they invest. Unlike individual bonds, the interest income from a bond fund is not fixed, so there is no fixed maturity date. For the past several decades, declining interest rates have generally boosted the net asset value of bond funds. Consider the inverse: When interest rates rise, bond fund values tend to decline, exposing an investor’s principal to risk.

In a period of rising interest rates, investing in a ladder of individual bonds and holding them to maturity can help mitigate the principal risk inherent in investing in a single bond. A bond ladder is a diversified portfolio of individual bonds with staggered maturities. At each interval, a portion of the bonds in the ladder mature, and the proceeds may be reinvested at the then-prevailing interest rates, which may be higher or lower than the original rate, or used for other purposes.

Bond ladders offer the benefit of a predictable income stream derived from interest payments and periodically maturing bonds. Through bond ladders, investors can build a diversified bond portfolio that provides a mix of yield and credit quality tailored to one’s individual needs, time horizon and risk tolerance.

Considerations for bond investing

Each investor’s needs are different. When considering the appropriate bond strategy, please remember that there are risks associated with investing, such as interest-rate, market, credit and default risk. Diversification, convenience, cost, control and investment objectives should also be considered. To help educate themselves on the bond markets, investors can take advantage of the resources and tools companies like E*Trade Securities offer for finding the fixed income investments that are right for them and monitoring investments’ performance and credit quality.

It’s National Train Day tomorrow, and Amtrak is riding the rails. All aboard!

Good Links

Reuters: Bernanke warns lawmakers on looming fiscal risks

USA Today: Study: Economic mobility depends on the state you live in

Bloomberg: States borrow to cover pension fund shortfalls

Bond Buyer: MSRB cites cases that show need for better dealer fair-dealing

Morningstar: Another good analysis of how muniland has a lot more credit risk now

Reuters: Weekly U.S. muni fund inflows more than double – Lipper

Washington Monthly: Paying the toll for bridging the great divide

@Twitter Talk

Next week, not-for-profit hospitals to again face question from Congress: Do they deserve their tax exemptions? j.mp/J2UXcW

— Dan Diamond (@ddiamond) May 11, 2012

Set in a groove as numbers mirror previous weeks. Here is next week’s muni calendar: bit.ly/KOvkHt #muniland #munis — IpreoMuni (@IpreoMuni) May 10, 2012

truly the end of an era. what an amazing guy in #muniland. Austin Tobin has passed: bondbuyer.com/news/obituary-… — Taylor Riggs (@TaylorRiggs_BB) May 10, 2012

Cuomo moving to fire almost 200 state workers for abusing or neglecting disabled people in their care nydn.us/Jzbp2y

— Rachel Barnhart (@rachbarnhart) May 10, 2012

SEC files suit against former Detroit mayor for “brazen influence-peddling and betrayal of the public trust” huff.to/JzsAhZ #pensions — Pension Dialog (@PensionDialog) May 10, 2012

Broke Arizona town wastes nearly 10% of annual budget subsidizing professional hockey: is.gd/HD5SoA — Matt Welch (@mleewelch) May 10, 2012

2nd time n 3 days heavily dominated GOP Leg speeds over a Repub: guy w/tire marks is Gov Robert Bentley #alpolitics twitter.com/birmingham_new…

— Chuck Dean (@BhamnewsDean) May 11, 2012

Last month, Puerto Rico Governor Luis Fortuño delivered a speech at the libertarian Reason Foundation on “how Puerto Rico avoided becoming “America’s Greece.” In his talk, the governor espoused the anti-government ethos of Grover Norquist, whom he cited as a friend in the first minute of his remarks. Fortuño has been a staunch advocate of “right-sizing” government: Soon after taking office, he laid off a substantial number of the commonwealth’s employees and reduced the island’s personal, corporate and property taxes.

Despite these cuts, Puerto Rico’s budget is still unbalanced. Fortuño has been relying on bond issuance through COFINA, the government’s off-balance-sheet, special-purpose vehicle, to make up for annual shortfalls to his budget.

Now, Republicans in Congress are working to blow another hole in Fortuño’s budget. As part of their effort to stave off the impending, automatic cuts to the defense budget, House Republicans passed legislation that kills a special provision of the Affordable Care Act increasing Medicaid grants to Puerto Rico. Faced with the threat of losing billions of dollars in federal payments each year, Fortuño now seems to think that lower federal spending is not that appealing. He pushed back on these cuts in an op-ed on CNN.com:

Historically, Puerto Rico’s Medicaid program has been chronically underfunded by the federal government. In 2010, Puerto Rico and the other territories secured corrective legislation to provide $6.3 billion in Medicaid funding over 10 years, which includes $5.4 billion for Puerto Rico.

[...]

Now, House Republicans have assembled a package of budget cuts to replace the automatic, across-the-board sequester. The proposal does not cut the Medicaid expansion funds for the 50 states, but Puerto Rico’s $5.4 billion Medicaid provision has been singled out for elimination.

It’s important to note that residents of Puerto Rico are already treated differently in the federal government’s eyes, at least when it comes to the tax code. Its residents do not pay federal income tax on money earned within Puerto Rico, making federal tax collections there much smaller than in any U.S. state. The most recent data available showed federal per capita collections of $888; West Virginia, the state with the second-lowest federal per capita collections, took in $3,599. According to the AARP, Puerto Rico has a higher percentage of residents receiving Social Security than the national average, and only half of those recipients are retirees.

When the food stamp program was modified in 1977 to cover Puerto Rico, 56 percent of the island’s residents signed up to receive those benefits. Although Puerto Rico represents barely more than 1 percent of the national population, Puerto Ricans accounts for about 8 percent of federal dollars spent through the food stamp program. After Congress later modified the program, the percentage of Puerto Rico’s population on food stamps fell, to about 25 percent today, but that’s still well over the national usage rate of 15 percent.

From these figures, it’s clear that Puerto Rico is a very poor place and needs support from the mainland. Given the fragility of the island’s economy, its massive debt load and its need for support from the rest of the nation, Fortuño might do well to break with Grover Norquist and his anti-government message. It’s the taxes he rails against that are helping his people.

Bob Nelson of Thomson Reuters Municipal Market Data and I, along with several others, went back and forth on Twitter about how public pension funds manage their investments. Nelson tweeted out the chart above comparing the investment returns for Calpers, the giant California public employee pension fund, with index returns for equities and fixed income. It looks as if Calpers has some very good returns.

Good Links

Moody’s: Austerity challenges the U.S. outlook

U.S. DOJ: From 2010 to 2011 the number of people in county and city jails (735,601) declined by 1.8 percent

WM Financial Strategies: Nice roundup of muniland regulatory issues

Bloomberg: Governments belatedly put pension deficits on their books

StlToday.com: Tax support for mall gains despite opposition

The Daily Journal: More fiscal fandango: New Jersey budget relies on one-shot solutions

NYT: Austerity rears its head in a liberal New Jersey town

Albany Times Union: Investigation raises alarm on overuse of anti-psychotic drugs in nursing homes

@Twitter Talk

FRED has a new look, but we also added new features like data tags bit.ly/IbQyQW

— St. Louis Fed (@stlouisfed) May 8, 2012

Private industry workers get 29.5% of their comp in benefits. State & local govt workers, 34.6%1.usa.gov/gNO9X via BLS — David Wessel (@davidmwessel) May 9, 2012

Rental vacancy rates by state & homeowner vacancy rates by state (1st Q 2012) ow.ly/aNe9W #Census

— Barrett and Greene (@GreeneBarrett) May 9, 2012

Laura Porter of Fitch Ratings U.S. Public Finance group discusses online sales tax with @FoxBusiness ow.ly/aMF1N #muniland — Fitch Ratings (@FitchRatings) May 9, 2012

The tension between the federal government and medical marijuana states continues, as 25 Colorado dispensaries close. denverpost.com/news/ci_205784…

— Michael Cooper (@coopnytimes) May 9, 2012

Breaking: Postal Service will drop plans to close up to 3,700 mostly rural post offices, citing customer outcry.on.wsj.com/LO3Oig — Wall Street Journal (@WSJ) May 9, 2012

@CAController reports April revenues $2.44b below projections in Governor’s budget 1.usa.gov/K8NNDd #cabudget — CA State Controller (@CAController) May 8, 2012

Why a Minnesota lawmaker – who happens to be a sports economist – voted against taxpayer money for Vikings stadium ti.me/JpukwG — Rachel Barnhart (@rachbarnhart) May 9, 2012

Glendale, Arizona taxpayers can’t ignore the NHL’s Coyotes — and their $12.9m projected annual loss for the city. on.wsj.com/JfsFrT — Wall Street Journal (@WSJ) May 9, 2012

• General Obligation Bonds (Appropriation debt)
• Sales Tax Revenue Bonds
• Gas Tax Revenue Bonds
• Toll Revenue Bonds
• Federal Grant-Secured Obligations (GANs/GARVEEs)
• Transportation Infrastructure Finance and Innovation Act (TIFIA) loans
• Public Private Partnerships (P3)

The top five categories in the list above are types of municipal bonds, meaning that they require a local or state government to take on debt to fund infrastructure. At the level of federal financing, the U.S. Department of Transportation’s Federal Highway Administration gives out TIFIA loans to public-and-private infrastructure projects. For example, the Macquarie-owned public-private partnerships that are building the Midtown Tunnel in the Norfolk and Hampton Bays area of Virginia and the FasTracks rail project in Denver are using federal TIFIA loans in the funding pool.

I don’t really understand why the FHA’s TIFIA program favors private investment. Here’s what the FHA website says (emphasis mine):

The program’s fundamental goal is to leverage Federal funds by attracting substantial private and other non-Federal co-investment in critical improvements to the nation’s surface transportation system. TIFIA was created because state and local governments that sought to finance large-scale transportation projects with tolls and other forms of user-backed revenue often had difficulty obtaining financing at reasonable rates due to the uncertainties associated with these revenue streams.

I’m sure the FHA folks know about the $230 billion of transportation bonds outstanding (page 13). Many of these securities are repaid with tolls. In fact, the FHA’s own website lists public projects that are owned by municipal and state governments and repaid with toll fees. It’s no surprise that public toll roads charge users lower fees than do those involving private investors, but that is not an explicit program goal of the FHA, unfortunately.

The webinar highlighted a study S&P conducted about cash flows on publicly and privately owned toll roads (emphasis mine, page 13):

We compared pairs of similar publicly and privately operated toll roads in Denver, CO, Southern CA, Dulles VA, and Chicago, IL

•  Roads were privatized over the last 15 years
•  Roads compared were higher cost in terms of toll rate per mile than large, well-established statewide systems
•  All had high usage of electronic toll collection, most above 75%
•  Toll rate increases were greater than inflation, but the private roads were slightly higher

TIFIA could be an enormous engine for expanding American infrastructure and creating jobs if it shifted its focus from enabling the privatization of public assets to backstopping municipal governments that issue debt to fund transportation projects. The TIFIA program could reshape itself into a bond guarantor and stand between bond investors and municipal governments. There is certainly demand – as FHA has said, the program was oversubscribed for 2012 projects. For example the New York State Thruway Authority applied for $2 billion in TIFIA funds for the new Tappan Zee Bridge it hopes to build.

The United States is still a very rich country. We have the resources to improve our national assets. But it’s deeply disappointing that a federal program uses scarce resources to privatize public assets. Governments must retain as many of their revenues and assets as possible to fund future needs.