A Debt Deal In Puerto Rico, But It Isn't The People Who Are Celebrating

Bondholders may feel reassured by yet another round of austerity just proposed by the Puerto Rican government. They may also feel confident about the first restructuring agreement reached, when it had been declared un-payable only a few months ago.

After a deal was struck by Puerto Rico’s Electric Power Authority and municipal bond and hedge funds, you can guess who did the celebrating. Whereas the market had been expecting large losses, negotiators struck a debt haircut of just 15%. Moreover, the concession is not free since bondholders managed to make the debt safer, maybe even investment grade, by giving themselves a claim on company revenues, essentially forcing a bankrupt entity to hike the price of electricity.

There’s plenty of money to be made in an island in desperate straits

The agreement is far from final, but the market received the news with a sigh of relief. Puerto Rican bond prices rose as it became clear that local negotiators would be easy prey and that there will be plenty of money to be made in an island in desperate straits. Hedge funds that bought debt at a 50% discount, will be able to sell it at a much higher price. Restructuring advisors did not do badly either, earning over $30 million in fees and bonuses.

How did the hedge and municipal bond funds and government advisors achieved this and what are the lessons for investors? The first is that debt only appears to have been un-payable—a 15% cut will do. The second is that local government officials will not refuse an offer that allows them to kick the can down the road. The deal was sold the moment bondholders offered to defer principal payment for five years, at a fee. Third, when restructuring firms get paid for restructuring debt, they will restructure at whatever price it takes, an eminently rational response given that fees are not tied to performance on behalf of the client. One can imagine that the outcome would have been different if they had been linked to the size of the bond haircut and to the long-term success of the power company.

Investors got what they wanted: a higher probability of getting most of their money back

The deal, still on the works, is likely to be heavy on the financial details but mute on how the mountain of debt will be re-paid. The power company still faces bleak prospects associated with operating in a country with a continually declining customer base due to a ten-year recession, poor demographics, substantial out-migration and advances in technology. Whereas in most of the world alternative energy is still an environmental proposition, in Puerto Rico it is a sound economic one. Power rates are so high that it is cheaper to set up individual systems such as solar panels in housing and commercial units. Rate increases will do wonders for clean energy production, but nothing to increase the survivability of the public utility.

If there are no customers left in Puerto Rico, who is going to pay the bill? (Photographer: Derick E. Hingle/Bloomberg)

Orlando Sotomayor

Mr. Sotomayor is a professor of economics at the University of Puerto Rico.

A Debt Deal In Puerto Rico, But It Isn't The People Who Are Celebrating