Muni Opinion Fixed Income

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1 Strategy Insights December 2013 Muni Opinion Fixed Income Volatile territory: a balanced view of Puerto Rico debt Recent headlines regarding Puerto Rico s debt burden have unnerved investors and caused significant price declines and volatility in the Commonwealth s bonds. This month we thought we would give some background on Puerto Rico s fiscal challenges and discuss how investors should view bonds backed by various Puerto Rico issuers. A lot has happened since the last time we discussed Puerto Rico in The Muni Opinion. A few key developments have been the election of a new governor, credit downgrades by the three major credit-rating agencies, passage of meaningful pension reform legislation, release of a budget with increased revenues and cost control measures, and increased public awareness of the Commonwealth s underlying credit characteristics. All of these factors have been important, some for positive reasons, others for negative, but the last point has been especially relevant for bond holders in recent months. As the fiscal and economic challenges facing Puerto Rico have become better known, prices on the Commonwealth s bonds have fallen and experienced above-average price volatility. Yields on Puerto Rico debt have increased by more than two percentage points as certain investors have sought to reduce exposure to the credit. Contributors Gene Caponi, CFA, portfolio manager, senior municipal research analyst, Deutsche Asset & Wealth Management Philip G. Condon, head of municipal bond portfolio management, Deutsche Asset & Wealth Management Carol L. Flynn, CFA, head of municipal bond research, Deutsche Asset & Wealth Management Ashton P. Goodfield, CFA, head of municipal bond trading, Deutsche Asset & Wealth Management Kevin M. Walsh, CFA, investment specialist, Deutsche Asset & Wealth Management

2 The Commonwealth s low BBB credit quality has always been well below that of most U.S. state general obligation bonds, whose average credit rating is AA. 1 Because of the credit trend over the past decade, many bond-market participants, including our portfolio team, have been cautioning investors against overexposure to Puerto Rico debt for some time. But the violent price reactions that Puerto Rico bonds have seen following recent headlines, greatly magnified by market technical factors, have been a surprise to most. In the following pages, we ll provide a balanced review of the fundamental credit and technical situation, the various types of Puerto Rico debt, and how recent changes will affect the Commonwealth, as well as its bondholders. A brief overview of Puerto Rico bonds The large increase in outstanding Puerto Rico debt in recent years has come as a surprise to many people. Since 2007, Puerto Rico has funded central capital projects and a portion of operating deficits with bond proceeds. The total public debt burden now stands at more than $70 billion. Tax-supported debt, which excludes self-supporting and enterprise debt, has risen to 52% of gross domestic product (GDP), or 3.4 times the governmental funds revenue. 2 Debt service is about 12% of the governmental funds budget. What concerns us most is not the current level and affordability of Puerto Rico s debt, but the pace at which the debt has been increasing. If debt levels continue to rise at the same pace they have been increasing in recent years, the situation will become unsustainable, in our opinion. What s been most surprising to some municipal-bond investors is the fact that many retail portfolios had high, in some cases double-digit, percentage concentrations of bonds issued by Puerto Rico. Investors in state-specific funds often times thought they were invested only in bonds issued within their state, while in fact they were invested in bonds that are not taxable in their state. This includes debt issued by U.S. territories, most notably Puerto Rico. The island s fiscal and economic situation has been the subject of media and market attention over the last several years, with the focus becoming more intense this past August. With negative articles coming on the heels of this summer s bond-market correction, Detroit s municipal bankruptcy filing and significant redemptions out of bond mutual funds, the market has harshly punished the market price of all Puerto Rico bonds. The selling came not only from U.S. mutual-fund and private-account investors, but, significantly, from investors on the island itself. In many cases, these large investors had taken on leverage to invest and bought funds that implement leverage. This leverage upon leverage made the downward pressure on prices more extreme when forced selling began. In our view, some positive effects have resulted from the increased credit scrutiny and higher bond yields. First, Commonwealth law makers have been forced to focus on making hard budget decisions and reducing the amount of new debt that will be issued in the near future. A second constructive market outcome has been the broadening of demand for Puerto Rico bonds. Non-traditional crossover buyers, including taxable private, hedge, and credit opportunity funds, have increased their knowledge of the credit and have been significant marginal buyers of Puerto Rico bonds. Last, we ve recently seen a greater effort toward investor outreach and signs of better market disclosure from Commonwealth officials. Though not currently an institutional practice, we d view receiving prepared multi-year financial plans as another substantive step in the right direction. Fundamental credit characteristics With a population of 3.7 million, Puerto Rico is a territory of the United States under the supervision of Congress. Congress and island voters approved Puerto Rico s constitution in 1952, establishing Puerto Rico as a Commonwealth with a common defense, market, currency and citizenship. Residents serve in the U.S. military. In prior decades the island economy has been closely linked to the U.S. mainland. Economic output has been heavily reliant on manufacturing exports flowing to the states. Figure 1 outlines several of the key developments that have occurred in Puerto Rico in recent years. 2

3 So how did the situation in Puerto Rico become so problematic? For most of the 1980s and 1990s, up to the mid-2000s Puerto Rico s economy correlated fairly well to the U.S. economy. Almost half of Puerto Rico s economic output is generated by manufacturing, and more than 70% of exports flow to the mainland. Between 1996 and 2006 the corporate section 936 federal tax credit which effectively exempted income earned by U.S. corporate subsidiaries operating on the island from federal corporate income taxes was phased out. The economic downturn, which began in the middle of 2006, was related to the phaseout of section 936 and rising oil prices, followed by the worldwide Great Recession and Commonwealth government downsizing. Real gross national product (GNP) hit trough annual declines of 3.8% and 3.6% in fiscal years 2009 and 2010 (as Figure 2 shows), with the unemployment rate peaking at 16.9%. 3 Population decline has also occurred, consistent with the historical pattern of the mainland serving as an economic safety valve. Population loss has been at an average pace of 0.6% per year since Through the economic downturn, government finances have experienced persistent yet declining general operating deficits. Commonwealth leaders responded with expenditure reductions, including dramatic government job cuts, along with revenue-raising measures. Not unlike other states that have faced economic dislocations, officials have funded annual budget deficits with one-time measures and borrowings. Figure 1: Key developments in Puerto Rico December 2006: Puerto Rico enters recession, Moody s downgrades Puerto Rico debt to Baa3 and the Puerto Rico Sales Tax Financing Corporation (COFINA) is established as a deficit-financing mechanism. December 2007: The United States enters recession. May 2010: Republican Luis Fortuño from the New Progressive Party becomes governor, and Puerto Rico s unemployment rate peaks at 16.9% (vs. 9.6% in the United States). June 2011: Puerto Rico privatizes Highway 22. January 2012: Act 22, also known as the Act to Promote the Relocation of Investors to Puerto Rico, is passed. January 2013: Democrat Alejandro Padilla from the Popular Democratic Party becomes governor. February 2013: The Federal Aviation Administration approves the privatization of Luis Munoz Marin International Airport. March 2013: Standard & Poor s and Fitch downgrade the Commonwealth s general-obligation debt to BBB. April 2013: Puerto Rico passes Act 3, a pension reform act January 2006: The Section 936 possession tax credit is terminated for tax years after May 2007: Standard & Poor s downgrades Puerto Rico debt to BBB. November 2012: Puerto Ricans vote to become a state in a non-binding referendum. December 2012: Moody s downgrades the Commonwealth s general-obligation debt to Baa3. June 2013: The Puerto Rico Supreme Court upholds Act 3. July 2013: Puerto Rico passes Act 40, also known as the Law for the Redistribution and Adjustment of the Tax Responsibility, and the Puerto Rico Aqueduct and Sewer Authority (PRASA) approves a 60% waterrate hike effective July 15. August 2013: Puerto Rico sells $675 million of Puerto Rico Electric Power Authority (PREPA) bonds, funding two years of a capital improvement program (CIP) at around 7% yields, and a Barron s article prompts concerns September 2013: Puerto Rico announces that it has privately placed $800 million in highway Bond Anticipation Notes (BANs) repay the Government Development Bank (GDB), in addition to $600 million in Tax and Revenue Anticipations Notes (TRANs). A GDB review is announced. 3

4 Figure 2: Economic decline has not been as deep or as long as many people believe 6.0% Population (year-over-year percentage change) Real GNP (year-over-year percentage change) 4.0% 2.0% 0.0% 2.0% 4.0% 6.0% E In 2006, the Commonwealth legislature authorized an island-wide sales and use tax, which was partly leveraged to issue and secure Puerto Rico Sales Tax Financing Corporation (COFINA) bonds, the proceeds of which were used to help bridge what has become a lengthy transition period. A total of $15 billion of COFINA sales-tax bonds were issued beginning in In 2012 the island economy appeared to have recovered from bottom, with GNP and employment showing modest growth, and unemployment trending down to a monthly low of 13.0% in April For fiscal year 2013 the Commonwealth general fund sustained an adjusted budgetary operating deficit of $1.3 billion (15% of revenue), down from a peak budget deficit in fiscal year 2009 of $2.9 billion (37%). (See Figure 4.) Current credit conditions Average GNP growth Average population growth % 0.9% % 0.4% % 0.6% Source: World Bank and the Puerto Rico Planning Board as of September figures are estimates. There is no guarantee that forecasts will be realized. The public credit-rating agencies (Moody s, Standard & Poor s and Fitch) have responded to Puerto Rico s economic challenges by downgrading the Commonwealth s credit rating. They ve cited the stubbornly weak economy, growing debt burden, persistent structural budget imbalance and need to address a very large pension funding problem. Moody s downgrade of Puerto Rico in late 2012 to Baa3 with a negative outlook, just above the belowinvestment grade level, prompted Puerto Rico bond-market yields to increase and credit spreads to widen significantly. So far in calendar-year 2013, we believe the newly elected Commonwealth government has taken additional meaningful action to address the ongoing fiscal problem. First, legislation was passed to reform the employee retirement system, with significant change to move annual budget contributions to a manageable level (7% of budget). The expectation now is that the system will remain solvent over the next 45 years. Despite being legally challenged, the pension reform legislation was subsequently upheld by the Commonwealth s Supreme Court. Second, the current fiscal year 2014 budget included significant revenue and cost-control measures to reduce the structural budget deficit to a more moderate $820 million (8.6% of general fund revenue, or less than 1% of GDP). Key ingredients were a rise in corporate taxes and expansion of the sales and use tax, expected to produce more than a 20% increase in general fund base revenue. Third, action was taken to approve substantial increase in user rates and revenue for both the Puerto Rico Aqueduct & Sewer Authority (PRASA) and Puerto Rico Highways & Transportation Authority (PRHTA). Both essential enterprises have historically relied on government subsidies and loans to pay operating and capital expenses. The rate increases should help to make the enterprises self-supporting. 4

5 Last, with a legacy of having privatized the telephone, steamship, and a portion of toll-road enterprises, the Commonwealth closed a concession deal to lease the Luis Munoz International Airport. The airport enterprise received a significant up-front payment which was used to pay down debt, along with committed annual capital improvements. The government administration s goal is to achieve full structural budgetary balance for the fiscal year beginning July We believe that execution of this plan will very well be the key to maintaining investment grade credit ratings. Despite our perception of the Commonwealth s strong willingness to take corrective fiscal action, current budget uncertainty rests with revenue estimates, the economic impact of an expanded tax burden, the ability to adjust the budget, market access and vulnerability to world economic conditions. On a positive note, reported general-fund revenue for the first fiscal quarter of the fiscal year 6/30/14 has exceeded budget estimates. Moreover, Moody s, Standard & Poor s and Fitch recently affirmed Puerto Rico s investmentgrade general-obligation bond rating. Fitch placed Puerto Rico s general-obligation bond rating on watch negative, signaling that it will reach a decision whether to downgrade the credit to below investment grade by June We believe that the next milestones for evaluating the Commonwealth s credit rating should be ongoing monitoring of budget numbers, market access and review of the fiscal-year 2015 budget proposal early next year. Credit risks There are five credit risks we see, described below. Declining population and economic trend. Real GNP in Puerto Rico has declined in six of the last seven years. The economy and budget remain dependent on manufacturing output. Income levels are well below the average of the states, but above many sovereigns in the region. Figure 3 shows GDP per capita and highlights that while Puerto Rico falls short of the United States, its GDP is above average relative to Latin American countries. Substantial growth in the tax-supported debt burden. This is mostly attributable to deficit financing on top of capital issuance for a central, consolidated government. As Figure 5 shows, the net tax-supported debt of $53 billion (as calculated by Moody s) is equal to 52% of GDP, or 3.4 times the governmental funds revenue. This is a significant jump from tax-supported debt of $31 billion (as calculated by Moody s), or 34% of GDP in Another $18 billion of outstanding debt has been issued by component business enterprises that charge for their services. The larger employee pension system cash flow challenge has been addressed, but the teacher pension system funding still needs to be solved. Figure 3: GDP per capita $60,000 $50,000 $40,000 $30,000 $20,000 $10,000 $0 Ecuador Dominican Peru Colombia Panama Costa Republic Rica Mexico Brazil Argentina Venezuela Uruguay Chile Puerto Rico United States Source: The World Bank as of

6 Figure 4: Annual deficit (in millions) and percentage of general fund revenue $0 $500 4% $1,000 15% 9% $1,500 22% $2,000 $2,500 $3,000 37% 34% 27% $3,500 FY B 2015E Source: Financial Information and Operating Data Report as 10/18/ figure is budget goal figure is an estimate. There is no guarantee that forecasts will be realized. Figure 5: Net tax-supported debt (in millions) and percentage of GDP $60,000 $50,000 $40,000 $30,000 $20,000 $10,000 $0 34% 52% Source: Net tax-supported debt as calculated by Moody s as of Persistent yet declining general operating deficits. Over the past several years, operating budget deficits have become the norm in Puerto Rico. The deficits peaked at 37% of general fund revenue in 2009, as Figure 5 shows. This is made problematic by an uneven track record of meeting budget targets. Moreover, some recent tax increases are temporary and excess sales and use tax receipts (9% of general fund revenue) that flow to the general fund are subject to decline, as annual debt service on sales-taxbacked debt increases over time. Above average reliance on federal transfers and policy. One-fourth of Puerto Rico s aggregate personal income to individuals comes from federal transfer payments, with 70% from entitlement programs such as Social Security, veterans benefits, and Medicare. Other competitive constraints are the minimum wage law and the Jones Act. Minimum wage on the island is a challenge because Puerto Rico is subject to the same minimum wage as the United States, but the average wage in Puerto Rico is not significantly different from the minimum wage. Therefore, it is more expensive to hire new workers in Puerto Rico relative to the United States. The Jones Act requires that goods shipped or passengers conveyed between U.S. ports and Puerto Rico be carried on U.S. flagships, which some have argued reduces competition and increases costs for Puerto Rico. Recently weakened access to the public credit markets. The government plans to issue public bonds to refinance existing privately placed notes for liquidity management purposes by year end, depending on market conditions. However, the recent sharp increase in interest rates and credit spreads for Commonwealth bonds has created a condition of less certain affordable access to the public credit markets. Government officials are confident about having adequate financial liquidity through the middle of 2014, and sufficient capital demand from financial institutions and private investors. Aside from the challenges higher yields create in issuing new debt, market access could be reduced should budget estimates not be met and public credit ratings fall to below investment grade. If this were to happen, some investors 6

7 would not be able to purchase the bonds, and in some cases may have to sell any existing holdings. This could create further price volatility. In addition, the government has had inconsistent market disclosure practices, which may cause some investors to be hesitant to purchase the credit. Potential credit opportunities There are five potential credit opportunities we see, described below. Large population and economy, broad sovereign rights and fiscal autonomy. The tax base of Puerto Rico is broad. The top marginal individual income tax rate is 33%, the individual capital gain and dividend rate is 10%, the sales and use tax rate is 6.5%, and the top corporate tax rate is 39%. In many ways the government has more flexibility than do the U.S. states. Residents are not subject to U.S. federal income taxes, but are instead subject to income tax from the Commonwealth. The government offers substantial corporate tax incentives to promote business. There are strong economic, political and strategic ties with the United States, with monitoring and collaboration from Washington, D.C., and the Federal Reserve. Recent demonstration of willingness to take corrective fiscal action. As previously discussed, recently Puerto Rico has taken steps to improve the credit outlook on its bonds. First, the Commonwealth addressed the dire situation the pension plan was experiencing. The plan was on a path to run out of money by 2019, but pension reform has improved the cash-flow situation for 45 years, should assumptions hold. The current fiscal-stabilization plan also included budgeted increases in revenue, which should reduce the annual budget deficit, with a goal of eliminating deficit financing by fiscal year Finally, a plan has been implemented to move enterprise systems, such as PRASA and PRHTA, to self-sustainability. This would mean these authorities would become largely independent of the Puerto Rico s general fund. Figure 6: Puerto Rico: one of the jurisdictions with the highest industrial density of biotechnology Anglotech Lifescan Abbott Medical Optics Cardinal Health Edwards Lifesciences Integra Neuro Sciences TPI CDI Fenwal International Pace Analytical Rice Tec, Inc. Bayer-Cropscience Sartorious Stedirm Biotech AbbVie Biotechnology, LTD AbbVie Abbott Merck Monosanto Pfizer St. Jude Merck Essilor Covidien Zimmer Roche Diagnostics Classic Industries AbbVie Baxter Medtronic BASF Agrochemical Janssen-Ortho Bristol-Meyers Squibb Ortho Biologics Patheon Warner-Chilcott Venticon Boston Scientific Heraeus Pfizer Promed Fund, Investigación de Diego Steris BLU Pharma Astra Zeneca Biomet Eli Lilly Janssen-Ortho Janssen-Cilag Haemonetics Baxter Monsanto Illinois Crop Coopervision Pioneer-Hi-Bred Syngenta Seeds Sterl-Tech Becton Dickinson Stryker 3M Hill-Rom McNeil Merck Amgen Galephar Becton Dickinson Ethicon Eli Lilly Baxter Teva Pfizer Pall Warner-Chillcott Becton Dickinson Medtronic St. Jude Medical C-Axis Mylan Neolpharma Medtronic CR Bard Bristol-Myers Squibb Novartis Cardona Compounds Galephar TAPI Source: LaFortaleza and Caribbean Business as of 11/6/13. 7

8 A developed infrastructure, educational system and distribution network, as well as strategic proximity to Latin America and South America. Despite the economic transition Puerto Rico has recently endured, there are reasons to be optimistic about the potential of the island. The World Economic Forum s global competitive index ranks Puerto Rico s economic productivity number 30 in the world, the highest in the Latin America and Caribbean region. The economic strategy is geared to attracting highly skilled manufacturing and knowledge-based services, tourism, infrastructure, real estate and agriculture investment. Future job commitments from major companies have been announced, with expected multiplier effects. Figure 6 highlights the significant investment biotechnology firms have made on the island. Financial flexibility with demonstrated access to the public and private credit markets. While the increase in Puerto Rico s debt has been troubling, the bond- liability structure is favorable. There is some manageable exposure to bondanticipation notes. However, bond maturities are typically long-dated with attractive fixed interest cost, which means the recent increase in yields on the bonds is less likely to create problems associated with rolling over the current debt (such as some notable sovereign debtors have experienced). If all Puerto Rico debt were to mature today, and the Commonwealth had to issue new bonds at today s yields, we would be much more concerned. But the long maturities and attractive yields of existing debt make us more comfortable that the Commonwealth should be able to manage its cash flow. General obligation bonds have a constitutional first claim on Commonwealth resources. As we ve talked about in previous issues of The Muni Opinion, some generalobligation claims are stronger than others. Puerto Rico s general-obligation bonds have a strong pledge on revenue, and the Commonwealth s constitution is clear that interest payments take precedent over other expenses in the event of a cash shortfall. Debt service currently represents 12% of the fiscal year 2014 general fund budget, pensions 7% and discretionary expenses 56%. The Commonwealth has never defaulted on its debt. In summary, Puerto Rico s credit characteristics are unique among both municipal and sovereign borrowers. In our view, the Commonwealth has a reasonable plan and opportunity to stabilize its fiscal position. Success hinges on meeting budget targets and economic goals, as well as continued U.S. and world economic expansion. The challenges facing Puerto Rico stem from the fact that the market has clearly become inpatient with fiscal progress and concerned by the market rhetoric. Capital costs have increased, which could further strain the budget as the Commonwealth issues new bonds at higher yield levels. Should budget goals again fall well short of plan, public credit ratings will fall and market confidence will further erode. We deem bonds issued by Puerto Rico issuers to possess medium grade, moderate credit risk prone to above-average price volatility. For this reason, in our opinion, prudent value investment in Puerto Rico bonds should only be made in manageable amounts consistent with portfolio objectives and risk tolerances. When making specific investments, it is especially important to consider bond indenture legal rights and security provisions, such as the specific revenue source you depend on for your principal and interest. Various structures of Puerto Rico debt Commonwealth of Puerto Rico general-obligation bonds and Puerto Rico Public Buildings Authority bonds, guaranteed by the Commonwealth. The Constitution of Puerto Rico provides that general-obligation and guaranteed bonds constitute a first claim on Commonwealth resources. Commonwealth law provides for the secretary of the Treasury to make monthly transfers to a special sinking fund for the orderly payment of generalobligation debt service, held in trust with the Government Development Bank. Some may be concerned that Puerto Rico general-obligation debt is paid from the general fund, which supports other Commonwealth obligations, and that there would be competing claimants in the event of a cash shortfall. But, as previously discussed, in our view the law is clear that payment of debt is the first priority. The strength of the general-obligation pledge is strong, and the government relies on continued access to the capital markets. A default on debt would exacerbate any funding problems. We believe that legislators would likely go to great lengths to maintain access to the capital markets. Puerto Rico Sales Tax Financing Corporation (COFINA) bonds. COFINA issues bonds to provide funds for the Commonwealth to repay certain debt obligations. The bonds are payable and secured by a security interest in a specified portion of a newly created 5.5% Commonwealth sales and use tax. Law specifies that the first receipts of the sales tax in a specified amount be deposited in a special 8

9 dedicated sales tax fund, owned by COFINA and held separate and apart from the Commonwealth s general fund, for payment of bond debt service. The Commonwealth has covenanted that it will not limit or restrain the rights of COFINA to comply with its agreements with bondholders. Though the bonds are legally separately secured, COFINA s revenues and structure are related to the Commonwealth s fundamental credit position. For the full year 6/30/12, combined annual debt service coverage on the bonds was about 2x, which means the bonds are currently backed by an adequate revenue stream. Puerto Rico Electric Power Authority (PREPA) power revenue bonds. PREPA is responsible for electricity generation, transmission, and distribution. It is the sole essential provider of electricity on the island. The Authority is owned by the Commonwealth, but operates independently. It has autonomous rate setting authority to set and collect rates for electric service to produce sufficient revenues to cover operating costs, debt service, and other obligations. The power revenue bonds are secured by a senior lien on net revenues of the electric system. Although PREPA s enterprise revenue bond credit is self-supporting, the Commonwealth and its municipalities represent about 16% of PREPA annual electricity revenues. For the fiscalyear ending 6/30/12, audited annual debt service coverage was 1.9X, or 1.1x when adjusting for municipalities consumption and subsidies. Puerto Rico Aqueduct & Sewer Authority (PRASA) senior liens. PRASA owns and operates the public water supply and waste water systems. It is the sole provider of services in Puerto Rico, and has sole rate setting ability. The trust agreement establishes a gross lien on PRASA revenues as security for payment on senior bonds. PRASA finances have historically relied on budgetary appropriations from the Commonwealth to pay operating and capital expenses. For the fiscal year 6/30/12, audited annual senior debt service coverage from gross revenue was 8x. In June 2013, PRASA implemented a 60% average rate increase to provide additional revenues and improve net debt service coverage. Puerto Rico Highways & Transportation Authority (PRHTA) bonds. PRHTA is responsible for the construction of roads, highways and transportation facilities in the Commonwealth, with complete control and supervision of, and rate-setting ability for, owned facilities. Highway revenue bonds are payable from and secured by a gross pledge of certain revenues, including gasoline taxes, a portion of current gas oil taxes, a portion of motor vehicle license fees, and all toll revenues of financed facilities. Transportation revenue bonds are payable from and secured by pledge of certain revenues, including excise taxes and all toll revenues of financed facilities. All PRHTA tax and fee revenues are subject to being applied first to the generalobligation and guaranteed debt of the Commonwealth. Authority finances have historically relied on budgetary appropriations from the Commonwealth to pay operating and capital expenses. For the fiscal year 6/30/12, highway revenue audited annual senior debt service coverage from gross revenue was 2.6x. For the fiscal year 6/30/12, transportation revenue audited annual senior debt service coverage from gross revenue was 1.43x, and annual combined debt service coverage from gross revenues was 1.26x. In June 2013 a law was passed to increase the PRHTA s revenues by an estimated $270 million from license fee and petroleum and cigarette tax increases. The technical factor Aside from the normal factors that go into assessing if we want to add any medium grade BBB-quality credit issuer to a portfolio, there are a few additional factors that must be considered with Puerto Rico debt, such as the expected price volatility, lower liquidity and valuation uncertainty associated with supply and demand for higher risk credit. In recent months, not much has changed with the fundamental credit quality of Puerto Rico bonds, yet yields increased by more than two percentage points. The chart below shows yields on Puerto Rico bonds compared to California and Illinois bonds, both rated A, which also makes occasional headlines. You can see the yields have climbed on Puerto Rico debt relative to the two state credits, causing a relative loss of principal market value. As portfolio managers, we need to assess the potential market price volatility as well as the potential total return opportunity. The market price decline and volatility we ve seen in Puerto Rico bonds, mostly attributable to shifting perception and technical market demand, has been on par with what would be expected from the equity markets. So while we feel investors are currently being compensated for the risk they are taking in Puerto Rico bonds, we re cautious to add substantial exposure until we re more certain about the credit trend and market balance. That is why earlier we mentioned that exposure should be based upon risk tolerance. A moderate allocation to Puerto Rico will not noticeably impact the volatility of an entire portfolio, but too much exposure may keep investors up at night. 9

10 Figure 7: Puerto Rico vs. Illinois and California general-obligation bonds Puerto Rico California Illinios /06 04/07 04/08 04/09 04/10 04/11 04/12 04/13 Source: Barclays Capital as of 11/21/13. The bottom line Many of the fiscal changes that have been made in Puerto Rico, including pension reform and revenue increases are a positive development. Also, the Commonwealth s demonstrated desire to maintain market access is encouraging for bond holders. On the negative side, the continued rise in debt levels is discouraging, increased yields make issuing new debt more expensive, and the island economy has yet to see much growth. So what does all of this information mean? As we ve discussed, there are several reasons to own Puerto Rico debt, but there are several reasons to stay away. In the end, what is important is to align your Puerto Rico bond exposure (and your overall credit quality) with your risk tolerance. As mentioned, there is uncertainty about the Commonwealth s budget plan, investment-grade credit ratings and market confidence. But, in our view, the prospect for Puerto Rico s fundamental credit trend is actually better than it was several years ago. As is the case with many municipal issuers, Puerto Rico has various types of bonds available for investors. Puerto Rico bond issues have above average bond holder legal protections, with each bond structure backed by some sort of claim on revenue. Our team has invested more in a diverse mix of Puerto Rico revenue bonds compared to general-obligation claims. Though we re comfortable that Commonwealth general-obligation bonds have strong Constitutional protections, we still currently prefer bonds backed by a dedicated revenue source, and that have adequate debt service coverage. We believe there is the potential for very strong returns in Puerto Rico bonds, especially if a broadened base of investors gain confidence that the credit has stabilized. Much of the selling that took place in Puerto Rico bonds came from investors who were forced to sell for various reasons. In recent months non-traditional municipal-bond investors have started to purchase the bonds, which has stabilized prices. But, potential returns will not come without price volatility, and will be dependent upon continued improvement of fiscal and economic conditions. Each negative headline that addresses the Commonwealth s fiscal challenges creates a real potential for another round of price volatility. We continue to keep manageable exposure in order to minimize that volatility for our clients. 10

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12 1 Credit quality measures a bond issuer s ability to repay interest and principal in a timely manner. Rating agencies assign letter designations such as AAA, AA and so forth. The lower the rating, the higher the probability of default. Credit quality does not remove market risk and is subject to change. General-.obligation bonds are municipal bonds secured by an issuer s full faith and credit and taxing power. 2 Gross domestic product (GDP) is the value of all goods and services produced by a country s economy. 3 Gross national product (GNP) is economic statistic that measures what a country s citizens produced. It includes gross domestic product (GDP) plus any income earned by residents from overseas investments, but excludes income earned within the domestic economy by overseas residents. The opinions and forecasts expressed herein by the fund managers and product specialist do not necessarily reflect those of Deutsche Asset & Wealth Management, are as of December 2013 and may not come to pass. Important risk information Bond investments are subject to interest-rate and credit risks. When interest rates rise, bond prices generally fall. Credit risk refers to the ability of an issuer to make timely payments of principal and interest. Investments in lower-quality and non-rated securities present greater risk of loss than investments in higher-quality securities. The fund invests in inverse floaters, which are derivatives that involve leverage and could magnify the fund s gains or losses. Although the fund seeks income that is federally tax-free, a portion of the fund s distributions may be subject to federal, state and local taxes, including the alternative minimum tax. See the prospectus for details. Obtain a prospectus To obtain a summary prospectus, if available, or prospectus, download one from talk to your financial representative or call (800) We advise you to carefully consider the product s objectives, risks, charges and expenses before investing. The summary prospectus and prospectus contain this and other important information about the investment product. Please read the prospectus carefully before you invest. Investment products: No bank guarantee Not FDIC insured May lose value Investment products offered through DWS Investments Distributors, Inc. Advisory services offered through Deutsche Investment Management Americas, Inc. Deutsche Asset & Wealth Management represents the asset management and wealth management activities conducted by Deutsche Bank AG or any of its subsidiaries. Clients will be provided Deutsche Asset & Wealth Management products or services by one or more legal entities that will be identified to clients pursuant to the contracts, agreements, offering materials or other documentation relevant to such products or services. DWS Investments Distributors, Inc. 222 South Riverside Plaza Chicago, IL Tel (800) Deutsche Bank AG. All rights reserved. PM (12/13) R MUNI-OPIN-DEC RETAIL-PUBLIC

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