PREPA Restructuring Unlikely to Dim the Outlook for Revenue Bonds

Puerto Rico’s Electric Authority (PREPA), a government-owned utility, filed for bankruptcy in 2017 with approximately $8.4 billion of revenue debt. In August 2023, the federally appointed oversight board filed a proposed third amended Plan of Adjustment (POA) outlining a very low recovery for the utility’s debt.  The basis for the low recovery is partially driven by several unfavorable court rulings, which some market watchers believe cast doubt on the strength of municipal revenue bonds. While we believe the outcome in PREPA is unlikely to dim the prospects for revenue bonds, the case serves as a reminder that investors cannot passively assume that all revenue bonds are equal.

PREPA Recovery Proposal

Puerto Rico’s long-standing bankruptcy is approaching a conclusion as PREPA remains the only major debtor on the island still negotiating with creditors in Title III bankruptcy. PREPA bonds have recently traded around 25 cents on the dollar (Figure 1)—a level we believe is unjustified given the expected lower recovery for bondholders. The POA outlined a 12.5% recovery for PREPA consenting bondholders and a 3.5% recovery for non-consenting bondholders. The plan also includes a Contingent Value Instrument, although this feature is expected to provide only a marginal increase to the recovery rate. In a sector where bankruptcies are exceedingly rare, the recovery rates also appeared surprisingly low.

Figure 1: PREPA Bonds Trade Lower Following Adverse Rulings

Source: Bloomberg, September 2023.

During the pendency of PREPA’s Title III bankruptcy, the judge rendered several highly technical decisions that were detrimental to bondholders and contributed to the low recoveries in the POA. In one decision, the judge classified bondholders’ lien on PREPA’s revenues as unsecured and then, in a subsequent decision, limited bondholders’ unsecured claim to $2.38 billion, or approximately 28% of bonds outstanding. The situation serves as a reminder of the nuances that can emerge in corners of the municipal bond market and require thorough analysis of the offering documentation.

Bond documents for a typical municipal revenue bond establish the source of revenues to repay the bonds and place a secured lien upon and/or pledge of the identified revenue source. Some investors specifically seek out revenue bonds, as opposed to general obligation municipal bonds, because of these attributes.

Unfortunately, the language in the PREPA documents is ambiguous. The security section of the PREPA Official Statement, as an example, states that bonds are deemed payable from utility revenues. However, that language and similar statements in the bond indenture failed, in the eyes of the court, to adequately grant a secured interest in the utility revenues. While the PREPA bond documents include a sinking fund deposit covenant and a rate covenant, there is a strong precedent that covenants are not enforceable in bankruptcy.

The latest POA has support from over 40% of bondholders, but there are several large holders that are appealing the judge’s decisions. Plan confirmation hearings are not scheduled until March 2024, and there is a chance that objecting bondholders succeed with all, or part, of their appeals, or that the POA is once again re-negotiated.

Revenue Bonds Here to Stay

Revenue bonds comprise nearly 70% of the municipal bond market (Figure 2). The category includes a variety of issuers representing sectors such as transportation, healthcare and education entities, and essential service utilities, such as water and sewer and electric utilities.

Figure 2: Barclays Municipal Bond Index (%)

Source: Bloomberg, October 2023.

Revenue bonds issued by municipalities typically benefit from a “special revenue” designation under Chapter 9 of the bankruptcy code. This designation was added to the bankruptcy code in 1988 to ensure that revenues pledged to pay bonds used to finance critical U.S. infrastructure assets would remain subject to any lien granted prior to commencement of a debtor’s bankruptcy and continue post-petition. But because language in the PREPA documents did not adequately establish a lien on revenues, the protections provided by the special revenue designation did not apply. The judge’s unfamiliarity with the concept of special revenues may have also contributed to her rulings.

However, it would be incorrect for investors to infer from the Puerto Rico rulings that all revenue bonds are now weaker than they were previously. We remind investors that despite frequent doom-and-gloom headlines, municipal defaults remain rare, especially relative to corporate defaults (Figure 3).

Figure 3: Municipal Defaults vs. Corporate Defaults (%)

Source: Moody's Investors Service.

In addition, several municipal bankruptcies have provided precedent for the preservation of special revenues. In the Jefferson County bankruptcy cases, for example, water and sewer revenue bonds were not impaired. Additionally, in Detroit’s high-profile bankruptcy, the payment of principal and interest on the city’s essential service water and sewer bonds was uninterrupted.

Conclusion

Revenue bonds benefit from security features that ensure a state and local government’s continued access to financing for critical infrastructure. The PREPA ruling is largely the result of ambiguous language in the original PREPA bond documents and should have little impact on the market’s confidence in the strength of the wider universe of revenue bonds.

Yet, the situation should remind investors of the need to carefully review a revenue bond’s security provisions to gain comfort that the designation would likely apply if the borrower were to become distressed. While special revenues should prevail in the future, the PREPA case underscores that idiosyncrasies can exist in a nuanced sector which requires thorough credit analysis.

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