MUNICIPAL BOND RESEARCH

Commonwealth of Puerto Rico

A Status Update
Report Date: 03/04/2014 Executive Summary: The Commonwealth of Puerto Rico (PR) is poised to issue what could be the largest high yield municipal issue ever, up to $3.5 billion of new G.O. debt to satisfy short-term liquidity needs and demonstrate market access to the rating agencies. While the issue is expected to get a strong reception thanks largely to favorable market technicals, it may turn out to be just a temporary reprieve that does nothing to resolve any of the long-term credit issues. The new issue will surely come at a high cost to the island. Aside from the projected double-digit yield required to entice non-traditional muni investors, the Commonwealth may also be asked to partially relinquish its sovereign immunity. Hedge fund buyers have been pushing for the right to sue the island in New York district court instead of local court. At this writing, the PR Senate has approved the new bond issue with the provisos allowing lawsuits related to this issue to be heard in New York, while expressly retaining sovereign immunity with respect to any property associated with such lawsuits. Credit spreads for PR G.O. paper reached record levels in early February, even exceeding those of troubled sovereign issuers such as Greece, as market speculation swirled around what it might cost the Commonwealth to re-gain access to the market. Ironically, in typical sell the rumor, buy the news fashion, the long-overdue round of downgrades by the rating agencies turned out to be the catalyst the PR market needed for a sharp rebound. Buyers were further encouraged when the dreaded forced selling by the mutual funds failed to materialize. At this point, assuming the new bond issue is successfully placed, we believe the worst is probably over for Puerto Rico bonds, at least for the next 6 months. Even though the Padilla team is facing high debt acceleration risk as a result of downgrades (see below), most creditors realize its not in their best interest to force the issue at this time and thus should be quite willing to work with the Commonwealth. Looking beyond the need for short-term liquidity, we fear the Commonwealth may have passed up a historic opportunity to restructure it crushing debt burden once and for all. With the debt already trading in the 60-70 dollar range, it would have been, in our view, the perfect time to ask bondholders for a temporary debt moratorium and plow the debt service savings into an aggressive
Copyright 2014 (Axios Advisors, LLC) All Rights Reserved. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase and sale of any security. Although the information contained in this report has been obtained from sources we deem reliable, we do not guarantee its accuracy, and such information may be incomplete or condensed. Investors should obtain and read the official statements related to the securities discussed. All opinions are only valid as of the report date and are subject to change without notice. Axios Advisors, LLC (or one of its affiliates), or its employees or clients may have positions in the securities described herein and may, as a principal or agent, buy and sell such securities.

package of economic development incentives designed to jolt the island out of recession. If successful, such a strategy would have ensured that bondholders will ultimately be made whole while also putting PR back on a more sustainable economic growth path. Another long-term solution that has been discussed among industry experts would involve the creation of a super-agency modeled after New Yorks Municipal Assistance Corp. (MAC), perhaps with some federal backing, to help PR regain access to the capital market after the debt restructuring. However, any debt restructuring scenario would be anathema to a new Administration still trying to deflect the blame for a historic downgrade into junk territory. Rather than make the hard decisions, the politician instinct is always to kick the can down the road. And so, as a result, PR will continue to limp along with an even higher (and more expensive) debt burden and, potentially, a two-tiered capital structure, until the realities of a shrinking economy reassert themselves once again. Ratings Changes: Ratings downgrades were issued on 2/4/14 by S&P, 2/7/14 by Moodys and 2/10/14 by Fitch. Following are the ratings by issuer as they currently stand: Issuer S&P Moodys Ba2 Ba2 Baa1 Baa2 Ba2 Ba1 Ba2 Ba3 Ba2 Ba2 Ba2 Ba2 Ba3 BBBBB BB BB Fitch BB AAA+ BB+

Commonwealth GOs BB+ GDB BB COFINA Senior Lien AAFirst Subordinate Lien A+ PREPA BBB PR Hwys Highway Revenue Bonds BB+ Transportation Revenue Bonds BB+ Subordinate Transportation Revenue Bonds BB+ PRASA Revenue Bonds BB+ Guaranteed Bonds BB+ PBA BB+ PR Employees Retirement System BB PFC (Commonwealth Appropriation Bonds) BB Recent Market Performance:

According to Municipal Market Data (MMD), by early February, PR G.O. spreads versus the AAA scale had reached a record wide of 775 basis points (Bps) and 485 Bps for 10 year and 30 year maturities, respectively. Following the widely-anticipated round of downgrades by all 3 rating agencies to below-investment grade and the Administrations investor webcast on 2/18, PR bonds have staged a powerful rally resulting in spread tightening of about 100 Bps. 2

Despite the recent improvement, the PR yield curve remains significantly inverted, an indication that the market continues to assign a high probability of default in the short-term. Yield curve inversion could also be an artifact of PR bonds trading mainly on dollar price rather than yield, another indicator of financial distress. Chart 1: Puerto Rico G.O. Yield Spreads versus Generic AAA G.O. (Jan 2008-Feb 2014)
900 800 700 600 500 400 300 200 100 0 3/3/2008 3/3/2009 3/3/2010 3/3/2011 3/3/2012 3/3/2013 PR GO 30 yr Spread

PR GO 10 yr Spread

PR GO 20 yr Spread

Source: Thomson Reuters Municipal Market Data

Maturity Max Spread (BP) Current vs Max

10 Year 775 -125

20 Year 550 -100

30 Year 485 -95

Short-Term, Variable Rate and Derivative Exposure:

Acceleration Risk:
$188.7 million in GO VRDOs, $200 million PRHTA VRDOs, $249.5 million PREPA revolving line of credit LOC/Liquidity Facility Expiration: Same issues as above have LOC or Liquidity Facility expiration dates in May and June that could trigger MT resulting in acceleration Rate Increases: Downgrade has triggered rates to rise to 12%. Commonwealth plans to refinance GO VRDOs ($469 million) and COFINA BANs ($333 million) with upcoming GO Bond issue.

TRANs are due in equal installments in April, May and June, total of $1.1 billion. 3

valuation of $333.5 million as of 2/14/14. Currently, $142 million in collateral has been posted by Commonwealth and PBCs and documents provide for counterparties to require 100% collateral at any time. To date, none of the counterparties has exercised any tender, acceleration, put or termination rights. Commonwealth and GDB are in negotiations with swap counterparties, bondholders, and credit and liquidity facility providers in order to obtain waivers or modifications of certain of these requirements to mitigate the impact of the rating downgrades.

Swap and Derivative Risk: Those subject to termination have a negative mark-to-market

Tax Reform: We think a VAT is a possibility by FY16, replacing both Act 154 and individual SUT. The tax reform consultant group is the same group that recommended a VAT to the Calderon Administration back in 2000, and study results should be completed by December 2014. Impetus to replace Act 154 will be its replacement after it sunsets in FY17 with what Commonwealth officials term a burdensome income-source rule. Tax reform efforts at the Federal level could also have an impact on the islands revenues. House Ways and Means Committee chairman Dave Camps recent tax reform proposal would impose a higher tax rate on the subsidiaries of multinational manufacturers operating in Puerto Rico. Without going into all the intricacies of the proposal, most goods manufactured in Puerto Rico would have to be taxed at 25% of income by the federal or territorial governments, in effect ending the tax haven manufacturers have enjoyed on the island. There may be a silver lining in all this for PR, however: the proposal would make the new tax rate permanent rather than subject to periodic reauthorization by Congress, thus potentially creating a more stable tax regime. While the Camp draft has virtually no chance of advancing in its current form during this mid-term election year, the issues it raises could set the tone for the tax debate going forward. Transparency: With the Commonwealth readying an ambitious general obligation debt issue, investors have been treated to a wide range of financial disclosure that has been lacking in recent years. The bulk of the upcoming bond issue will be used to repay GDB loans and restructure debt. GDB: Liquidity concerns likely were the principal driver behind most of the rating downgrades, as GDBs lending practices were strained by the Commonwealth and its PBCs. Legislation has passed that permits repatriation of public deposits in the PR banking sector, which should have a dampening effect on the already stagnant economic picture, with such funds used to improve liquidity of GDB. COFIM (the municipal counterpart to COFINA) will be used first to repay $600 million in GDB loans to municipalities. The Commonwealth is restructuring the role played by GDB with respect to PBCs. Liquidity of GDB compromised by a number of factors: Increase in credit spreads for Commonwealth and PBCs during 2013 Limited market access for PR names 4

Significant reduction in liquidity in local PR capital markets Delays in repayment of GDB loans on part of Commonwealth and PBCs

Fiscal 2012, 2013 and Structural Deficit Prospects: FY 2012 revenues continued to come in behind budgeted estimates 9.3% increase in expenditures relative to budget, observed across the board with the exception of public housing and health care. Cash basis results for 2013 show a holding pattern in expenses and continued precipitous declines in principal tax revenues, despite Treasury officials swift action to reinstate Act 154 tax rates to original levels and to effect other revenue enhancements 2013 CAFR: Commonwealth officials have promised that the CAFR for FY2013 will be available earlier than has been the case in past years. For FY 2014, based on mid-year results, OMB expects the expenses to be held to within 1% of budgeted levels they were well below budget in almost every major expense category as of the first half of the year, but certain timing issues are expected to bring end of year expenses to roughly even with FY14 appropriations. Treasury estimates for FY2014 revenues show the rebound effect of the rate increases imposed in FY2013. Commonwealth plans to eliminate the structural deficit by FY15. Challenges associated with meeting such a goal include erosion of revenue due to economic slowdown, ability to effectively cut $1 billion in expenses through across-the-board agency cuts

Puerto Rico Electric Power Authority (PREPA): Operating Efficiency: expenses must be brought in line with reality CIP Is Ambitious: The benefits of a successful transition to natural gas notwithstanding, securing financing for this will challenge PREPA. Some transition has occurred and is encouraging. Are P3 solutions possible? Regulation Risk: legislation pending in both houses that would impose a regulatory agency to approve any rate increases as well as introduce FERC-style retail wheeling. PREPAs distribution and transmission facilities would be used with no direct benefits to PREPA.

Economy: At the end of the day, the future path of the PR economy will determine whether or not the Commonwealth will be back at the negotiating table with bondholders over the next 18 months. The short-term economic outlook does look grim indeed: the Commonwealths GNP has contracted in real terms every year except one since FY2007. The GDBs Economic Activity Index for calendar year 2013 showed a 4.3% decline compared to 2012. 5

Puerto Ricos employment reached its last peak in December 2006 and since then has declined by a stunning 20.7% through December 2013. According to the BLS, the jobless rate reached 15.5% in December 2013. More importantly, the island continues to lose its young, working-age population to out-migration to the US mainland. At least for now, the PR economy appears stuck in a vicious circle: revenue-raising measures taken to stabilize the fiscal situation have had the predictable effect of further depressing economic activity. Efforts to bolster liquidity at the GDB may also end up creating a credit crunch in the islands private bank sector. Efforts to reduce government spending must inevitably result in more cutbacks in public sector employment. With its back against the wall, the Padilla Administration has launched an aggressive economic development program to attract new industries to PR and is reportedly on track to create close to 10,000 new jobs during this fiscal year. While these efforts are certainly laudable, their economic impact may take years to materialize. The high cost of energy on the island is another critical issue for future economic development and a successful shift of PREPAs fuel mix toward natural gas will go a long way toward mitigating that problem. Given all the above, we suspect the current projected GNP decline of only 0.8% for FY2014 may well prove wildly optimistic. Other Technical Issues:

Impact on market indices: the migration of close to $70 billion in PR bonds from investment grade to high-yield indices may reduce demand from institutional investors. High yield funds may pick up some of the slack but probably not enough to offset lower demand from investment grade funds. Impact of the new Puerto Rico Investment Company Act of 2013 (PRICA): Previously, Puerto Ricobased investment companies were required to invest mainly in municipal debt issued by the island's government, in line with a 67% minimum investment requirement. The new law notably lowers the Puerto Rico investment requirement to 20% and allows PR-based funds to diversify their holdings away from local municipal debt, which may result in reduced demand and more selling pressure on PR paper.

Carol Karsten (ckarsten@axiosadvisors.com) Triet Nguyen (triet@axiosadvisors.com)