Investor Update – Puerto Rico

March 13, 2018

Rafael Costas and Sheila Amoroso 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 $68 billion as of January 31, 2018. At a fund level, currently, none of our municipal bond funds have more than 2% of their total net assets invested in Puerto Rico as of February 28, 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<link to Puerto Rico holdings document>

Puerto Rico Electric Power Authority (“PREPA”)

Our thoughts have been with our fellow American citizens in Puerto Rico as they rebuild after being hit by two hurricanes last year. In the wake of this devastation, restoring power to the island has been a priority and a challenge for the Puerto Rico Electric Power Authority (PREPA), Governor Ricardo Rosselló and the people of Puerto Rico. As of this writing, PREPA has recently reported that 89% of the island has had its power restored.

Over the past several months both the Oversight Board and Governor have attempted to put various people in oversight roles related to PREPA. First, the Oversight Board sought the appointment of a Chief Transformation Officer (CTO) to take over the day-to-day management of PREPA, but Judge Laura Taylor Swain rejected that appointment. Governor Rosselló subsequently appointed Carlos Torres, who oversaw the restoration of power in New York City after Superstorm Sandy, to lead the energy restoration effort in Puerto Rico. PREPA later appointed Todd Filsinger as its new Chief Financial Advisor to lead restructuring efforts.

On January 22, 2018, Governor Rosselló presented a plan that calls for the privatization of PREPA within the next 18 months, and he has also proposed a major overhaul to regulatory oversight of the electric utility. The plan would eliminate the Puerto Rico Energy Commission, the current regulatory body, and create a new Public Services Regulatory Board with bureaus assigned to oversee energy, telecommunications and transportation issues.

As a member of the Ad Hoc Bondholder group, we have said we welcome a range of potential strategies to improve PREPA and that 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. Thus, we support upholding the law and reaching consensus with stakeholders on the restructuring.

As has been reported, the Commonwealth of Puerto Rico and U.S. Government have had difficulty agreeing on terms for the release of federal disaster relief funding. In the interim, the Commonwealth filed a financing motion seeking to lend PREPA up to $1.3 billion on a first priming lien basis to address PREPA’s liquidity concerns. (The loan request was subsequently decreased to $1.0 billion.) The Ad Hoc Bondholder Group and other PREPA creditors filed an objection to the proposed loan alleging that, among other things, its terms would have impaired creditor collateral.

Judge Swain denied the Commonwealth’s financing motion in part because there was a loan available from a group of creditors on a non-priming basis that should have been considered. The judge approved a $300 million loan from the Commonwealth to PREPA. As of this writing, PREPA has not filed any additional motions for financing.

Background

In the midst of weakening financial conditions on the island, in 2014, then Puerto Rico 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.

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. The U.S. House and Senate subsequently approved disaster aid for Puerto Rico, though the details as to how that aid will be distributed are still being worked out.

In light of the focus on restoring services on the island immediately after the hurricane, certain litigation-related timelines in the Title III bankruptcy proceedings were initially extended by the federal court judge presiding over the cases or through agreement among the parties.

Over the last several months, litigation has since restarted and numerous hearings and rulings have resulted as the Title III restructuring process continues.

As the present time, Puerto Rico and several of its agencies continue to default on debt.