Rodney Johnson | Friday, November 01, 2013 >>
I never understood Puerto Rico.
The island-state is a U.S. territory, so we provide all security and handle all trade issues for them. The economy is based on U.S. dollars. Yet the population continually claims it doesn’t want to be the 51st state in the union.
Okay, the U.S. has problems, which our Congress has just illustrated in spades. There are pesky matters of entitlements and budget battles. We can’t agree on whether the U.S. Constitution is simply a guiding document or a series of principles that must be upheld.
We’re a bit bipolar. But c’mon… Puerto Rico is looking down at us?
Yes, it has beautiful beaches, and it also has a very cool rainforest up in the hills, but the island is an economic disaster.
The current rate of unemployment is 13.9%. This isn’t due to the financial crisis. Unemployment did spike in 2008-2009, but it was from an already high level of 11% up to more than 16%. And this is not new. In fact the only time since 1976 that Puerto Rico’s rate of unemployment has fallen below 10% was August through November of 2000. That’s it. A mere four months out of more than 35 years.
To make it worse, there were times when the unemployment rate was more than 20%, or one in five people in the work force.
Then there is the matter of how Puerto Rico manages its finances.
The country has more than $50 billion in debt outstanding, which equates to about $14,000 for every man, woman, and child on the island. This is 10 times the average level for the 50 states of the union. The island is expected to run a deficit of about $1 billion this year as well.
Looking at pension obligations only makes things worse. Puerto Rico owes almost $35 billion to current and future retirees, but has set aside a mere $5 billion. Given that a quarter of the workers on the island work for the governrnment, it doesn’t look like there are any good prospects for the economy to grow its way out of the current mess.
All of this might sound like the U.S. should simply let Puerto Rico drift into the economic abyss and work out its own problems, but it turnrns out that even if the territory is not a state, it’s still our problem. The reason is that the $50 billion Puerto Rico owes is in the form of municipal bonds sold to Americans.
Roughly 75% of all municipal-bond mutual funds own some Puerto Rico debt, and there are countless individuals that own this debt as well. What made debt offered by a perpetually anemic economy a good deal? The tax code, of course.
The U.S. governrnment wields the tax code like a weapon, choosing winners and losers all the time. Part of the way the governrnment entices investors is to give something tax-exempt status. Puerto Rico enjoys triple-exempt status, where its debt is exempt from all federal, state, and local taxes, no matter where you live.
If you happen to reside in the city of New York or San Francisco, then this could mean increasing your income by more than 50%. That’s not chump change. So as investors we could not resist the temptation.
As a U.S. territory, Puerto Rico enjoys many things, like being under our defense umbrella and having our trade agreements apply to the island.
However, the state must also live by certain rules that can be a problem. For instance, there is no provision for a U.S. Territory to go bankrupt. The theory is that the governrnment can simply continue to tax its citizens to make good on all obligations. This is a good theory, but a bad reality.
Politicians can make, and have made, promises they can’t keep. So Puerto Rico is in the ugly position of having to raise taxes and fees even though there doesn’t appear to be any way to solve its issues beyond stiffing some, if not all, of its creditors.
What happens to the U.S. holders of Puerto Rican debt?
That’s a really good question, and it’s also the reason that Puerto Rico-issued bonds trade at yields above 8% right now. I’d imagine that is cold comfort for those who have purchased such bonds in the past… but at least they can rest easy that whatever they eventually get from Puerto Rico will be tax free.
The good news is that Puerto Rico is making waves in the traditionally quiet pool of municipal bonds. This comes on the heels of Detroit going kaput.
With such a commotion, municipal bonds in general are selling off. This provides investors with an opportunity to scour the markets looking for bonds that have sold off in sympathy with the bad news.
The idea is to lock in yields higher than you would otherwise get and enjoy the tax-free interest for years to come. With the U.S. governrnment solving absolutely nothing and proving that it can kick our fiscal can down the road, higher taxes in the future look to be a sure bet.
Take any opportunity you have to reduce your taxable footprint.
P.S. Have you taken our survey yet? Harry wants to know the challenges you face as a budding entrepreneur during the economic Winter Season? It’ll only take you 2 minutes to fill out. Check it out here…
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Ahead of the Curve with Adam O’Dell
Investing for yield, or income, is nothing new. Bond investors have long earnrned sizeable returnrns this way.