Puerto Rico

August 1, 2018

Sheila Amoroso and Rafael Costas are co-directors of the Municipal Bond Department, Franklin Templeton Fixed Income Group®.

In our continuing efforts to keep our shareholders informed about events in Puerto Rico, we are providing this update.

For over 30 years, Franklin Advisers has been an investor in Puerto Rico bonds, which have historically been part of the investment opportunity set for municipal bond funds because of the bonds’ triple tax-free status (interest exempt from federal, state and local income taxes). Through the years, these bonds have been used to fund infrastructure projects across the island, including schools, public and private universities, hospitals, public housing, public buildings, airport facilities, transportation, electric utilities, water and sewer systems, as well as various economic development projects.

In 2012, we began reducing exposure to Puerto Rico-related bonds due to the weakening financial conditions on the island. We retained those investments that we believed were in the strongest position and felt had significant legal and constitutional protections by their indentures, applicable law and the Puerto Rico constitution.

In the years since, we have continued to selectively reduce our holdings and, as has been disclosed in certain legal filings, Franklin Advisers has sold all of its General Obligation and Public Building Authority bonds. Additionally, while we continue to believe strongly in the legal security of the Cofina bonds, we have significantly reduced our Cofina holdings, and as a result, we withdrew from all Cofina-related litigation and the Mutual Fund Group in early February. We continue to be a member of the PREPA Ad Hoc Bondholder Group, as the vast majority of our current holdings are in PREPA debt.

Puerto Rico debt now comprises less than 1% of our Franklin Tax-Free Income group's assets under management of over $65 billion as of June 30, 2018. At a fund level, currently, none of our municipal bond funds have more than 2.5% of their total net assets invested in Puerto Rico as of June 30, 2018—and many have no exposure. (Holdings in our funds are priced daily, and the prices of the individual securities reflect the current prices in the market.)

See the most recent detailed breakout of Puerto Rico-related holdings in our Franklin Tax-Free Income Funds at the link below:

Latest publicly disclosed Puerto Rico Holdings in Franklin Tax-Free Income Funds

Puerto Rico Electric Power Authority (“PREPA”)

On Monday, July 30, 2018, the PREPA Ad Hoc Bondholder Group, the Financial Oversight and Management Board of Puerto Rico (the Oversight Board), the Puerto Rico Fiscal Agency & Financial Advisory Authority (AAFAF) and PREPA announced agreement on a debt restructuring Term Sheet Agreement (TSA). Pursuant to the terms of the TSA, bondholders would exchange PREPA revenue bonds into new securitization debt. The new debt would be secured by a separate transition charge on ratepayer bills.

In conjunction with the TSA, the parties have entered into a preliminary Restructuring Support Agreement (RSA). This preliminary RSA is subject to revision as the parties work to finalize its terms over the coming months. Once a final RSA is agreed upon, the process to exchange the bonds would begin. While it is likely to take some time to get to an actual exchange of the bonds, the preliminary RSA marks a significant milestone towards commencing that process.

We have always taken a constructive approach to creating a path that will allow for the continued transformation and long-term sustainability of PREPA. We believe that this agreement will help create a positive economic impact for Puerto Rico and its people in addition to PREPA.

Background

In the midst of weakening financial conditions on the island, in 2014, then Governor Alejandro Garcia Padilla signed the Debt Enforcement and Recovery Act (“DERA”), which provided Puerto Rico with its own restructuring process. Within days, funds managed by Franklin as well as another mutual fund company filed suit stating that, among other things, DERA was unconstitutional.

In June 2015, while this case was being litigated, the Governor declared Puerto Rico’s debt unpayable and stopped paying debt service on certain bonds issued by the central government.

In June 2016, the case ultimately made its way to the U.S. Supreme Court, which ruled in our favor, affirming that neither Puerto Rico nor its municipalities or agencies can file for bankruptcy under a locally-enacted bankruptcy law and such entities are otherwise ineligible for Chapter 9 of the U.S. Bankruptcy Code.

As a result, later that June, President Obama signed the Puerto Rico Oversight, Management and Economic Stability Act (“PROMESA”), a bipartisan congressional effort that created an independent, seven-member Oversight Board for Puerto Rico. The Oversight Board was given fiscal oversight over Puerto Rico’s finances for an initial term of five years, with its term due to expire once Puerto Rico has posted four structurally balanced annual budgets in a row and is deemed to have “adequate access… at reasonable interest rates” to the capital markets. The Oversight Board has the power to approve or reject the general government’s proposed budgets until the board is satisfied that the budgets are structurally responsible and based on reasonable expectations and accounting standards.

Additionally, Title III of PROMESA provides Puerto Rico with a path for restructuring its debts following a process based on Chapter 9 of the U.S. Bankruptcy Code, with some important added protections and safeguards that are not available to creditors in a Chapter 9 proceeding. Title III is available to Puerto Rico and its related issuers only following good faith efforts to reach a consensual restructuring. Judge Laura Taylor Swain was appointed to oversee this Title III restructuring process.

In the time since, Puerto Rico and a number of its agencies, including PREPA and Cofina, have been working through this Title III restructuring process. Judge Swain asked that mediation be used to resolve issues in all Title III cases and appointed five sitting federal judges to serve as mediators in these cases. (The proceedings of mediation are confidential.)

In late 2017, hurricanes Maria and Irma hit Puerto Rico, inflicting significant damage to its infrastructure, including water, power and telecommunications, as well as damage to governmental, personal and business property. President Donald Trump issued a disaster declaration to make available federal funding for cleanup and rebuilding, and the U.S. House and Senate subsequently approved disaster aid for Puerto Rico.

As a member of the Ad Hoc Bondholder group, we welcome a range of potential strategies to improve PREPA and believe Puerto Rico would be better served by an electric utility run by a private operator with a proven track record, subject to independent, professional oversight by the existing Puerto Rico Energy Commission. But we also believe that the only path to deliver low cost and reliable power respects property rights, as failure to do so will result in years of litigation from multiple parties. We are hopeful that negotiations related to the preliminary RSA announced July 30 will be fruitful and constructive in paving the way for the continued transformation and long-term sustainability of PREPA.

As the present time, the Title III restructuring process continues, and Puerto Rico and several of its agencies continue to default on debt.