Hidden Gems in Puerto Rican Debt

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With this in mind, we sat down with Tim Bond, CIO of Gripman Funds, to talk about Puerto Rico Aqueduct and Sewage Authority (PRASA) notes. Mr. Bond (yes, that is his real name) pitched a long on PRASA notes on SumZero back in February, which has returned roughly 20% to date. Bond says there is still room for growth given the market’s blanket bearishness on anything Puerto Rico, leaving an opportunity that closely resembles Detroit’s debt crisis of several years ago.

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SumZero: What about PRASA bonds initially caught your attention as a value investor? What is the market and/or ratings agencies missing and why?

Tim Bond, Gripman Funds: Puerto Rico debt was issued by many different entities. PRASA debt caught my eye because PRASA is a water utility, provides an essential service and has essential assets. PRASA has a cash flow stream that is separate from the other entities of Puerto Rico.
The ratings agencies tend to rate debt upon the likeliness of default, yet in that headline rating there is no factor for recovery rate. Earlier this year all Puerto Rico debt traded at almost identical levels as a lot of investment grade-only accounts sold out of positions in late 2015, and the uncertainty caused by the complicated nature of Puerto Rico’s situation left potential buyers cautious.

A similar situation happened in the Detroit bankruptcy case where the Water and Sewer bonds were downgraded severely and prices were hit by forced selling. However, apart from a voluntary redemption, the remaining Detroit Water and Sewer Bonds came back to investment grade levels after the plan of adjustment.

SumZero: Puerto Rico has a reputation for horrendous finances. Why would anyone want to touch their debt? Why are they likely to actually pay it off?

Tim Bond, Gripman Funds: Puerto Rico does have economic struggles. As a stand-alone entity PRASA was able to increase rates, lower capex, and has continued to fund its restricted debt service buffers while remaining current on outstanding senior and most subordinated debt. Operationally, PRASA looks like a decent water and sewer utility judged by the most recent Debt Service Coverage metrics. However, because of lack of capital markets access for a long period of time and an inability to cut capex too far due to USDA and EPA mandated spending, the company has had to take steps to conserve cash.

PRASA is providing an essential service and I believe that the company already has the cash flow stream in place to operate effectively, so it’s worth considering investing in the debt. Since the bonds continue to trade at a decent discount to par, the potential for a good return remains favorable. I factor in some risk of extension of the outstanding debt or for a voluntary exchange, much like what was used in Detroit. However, especially in the case of the senior bonds, I continue to believe that an investor can buy the bonds at current levels and expect to have an option to hold the bonds until maturity and be paid at par.

SumZero: How does the international rates environment affect your thesis? Lots of unprecedented things are happening in the credit world right now, and there seems to be a large risk that rates will rise soon.

Tim Bond, Gripman Funds: Depending on your outlook for rates, an investor can find ways to protect against a rise in rates by looking for shorter duration bonds. Most of PRASA debt is longer dated and is exposed to rising interest rates. However, buying a tax free senior note at 7.5% or 11.3% adjusted for a 35% tax rate could provide a huge buffer to rising rates as long as the credit situation of Puerto Rico improves post restructuring.

SumZero: How can an investor execute this trade? Are there any good proxy trades to be made if one is unable to buy the bonds directly?

Tim Bond, Gripman Funds: PRASA bonds trade through traditional channels and around $18mm in purchases have been made over the past week. Some brokers do not allow the purchase of individual distressed bonds for retail investors and this may require investors to open accounts at more flexible brokers to purchase PRASA debt.

One proxy to consider is buying stock in some of the stronger financial guarantors. The only company that I would consider purchasing is Assured Guaranty LTD (AGO) stock at around $27. Post the broader Puerto Rico restructuring, the company will likely see some capital freed up to repurchase stock and the stock price should rise closer to book value of $47 per share minus about $3-7 per share for potential Puerto Rico losses.

SumZero: Are PRASA bonds still attractive to buy at today’s prices?

Tim Bond, Gripman Funds: Senior notes trade at $75. This converts to 7.5% unadjusted and 11.3% tax adjusted yield when accounting for a 35% tax rate (since municipal bonds are tax exempt investments). This continues to give some downside protection in case Puerto Rico tries to cram-down some type of haircut on bondholders.

SumZero: What key metrics should investors be paying attention to as your thesis matures?

Tim Bond, Gripman Funds: An investor should treat this investment as a very illiquid investment that should be held at least through the restructuring. I would continue to monitor performance of PRASA as new quarterly and annual financial disclosures are released. I would also monitor the restructuring process, but not get caught up in the ebb and flow of the events surrounding the resolution.

Detroit is a good case of what to expect. One would have thought that Detroit was apocalyptic around the time of their restructuring. There was a lot of negative press surrounding Detroit’s situation and on their deteriorating infrastructure. The Puerto Rico situation will be much the same; they will restructure and move on, much like Detroit.

SumZero: What were the biggest risks associated with the trade in your view?

Tim Bond, Gripman Funds: The biggest risks are the illiquidity of the bonds and the complicated nature of Puerto Rico’s finances. Questions like, “how do pensions get treated?”, “how are competing bondholder interests handled?”, and “can Puerto Rico turn around its economy longer-term?” are important and will lead to differing valuations. In PRASA, I believe that there is more protection of value compared to the other entities of Puerto Rico; people need water and sewers.

SumZero: Is this thesis representative of the Tim Bond and Gripman Funds investing style?

Tim Bond, Gripman Funds: Yes, we manage a balanced fund strategy that looks for good risk/reward opportunities across equity and fixed income. We are looking for what we consider mispriced securities/cash flows in any part of the capital structure/security structure. In this case, we hold PRASA bonds in our equity risk sleeve. YTD our strategy is up over 7%, and our Sharpe ratio is 2.75x.

SumZero: Where else do you see value in the market today?

Tim Bond, Gripman Funds: We build value from individual security selection to drive alpha for our clients. Each security we purchase we convert to a cash flow yield and make sure that we are getting the appropriate risk premium for each individual investment. We tend to be macro indifferent and do not attempt to forecast a specific macro scenario and invest to that end. Instead, we look for economic or volatility catalysts to drive changes to our portfolio over time.

SumZero: How has your approach evolved over the years?

Tim Bond, Gripman Funds: I have given up on hero investing. I don’t try to determine where a growth stock like Amazon should be valued and play the momentum stocks. I also take a pass on deep value stocks and bonds. These are situations that could work out really well if your base or positive scenarios work out, but you could potentially permanently lose significant amounts of capital as well if your negative scenario comes about. I obsess over how much potential permanent capital loss is possible in any investment idea.

SumZero: Tell me about your investing background and investing mentors and heroes.

Tim Bond, Gripman Funds: I started out as a Power Commodities Trader back in the days of Enron and shamefully actually traded a few MW on EnronOnline. After getting into the investment industry with an insurance company, I ended up with JPMorgan and I fell in love with investing and have not looked back.

My investment mentor was Doug Swanson, who managed the JPMorgan Core Bond Fund for many years and is now, unfortunately, out of the money management industry for the time being. He taught me and others in our group at JPM to invest for all scenarios and build portfolios of securities from the bottoms up to withstand every macro scenario.

My investment hero is Charlie Munger. His multidisciplinary approach to investing was a self-developed model of clear and simple thinking. I have taken a similar investing approach using all my personal experiences as well. I can’t come close to matching his knowledge, but I like to use and review his Brainiac titbits often. One of my favorites is his: “The Psychology of Human Misjudgment”.

SumZero: What advice would you give to someone interested in pursuing investing?

Tim Bond, Gripman Funds: Learn the difference between speculation and investing early and stick to investing.