Puerto Rico’s double-downgrade

Michael Taylor, Senior Municipal Analyst | February 10, 2014

  • What’s behind the downgrade of Puerto Rico’s credit ratings by Standard & Poor’s and Moody’s?
  • The double-downgrade puts pressure on Puerto Rico to shore up its finances in the coming weeks
  • A future default or debt restructuring could rattle investor confidence and impact all municipal market issuers

On February 4, Standard & Poor’s lowered its long-term credit rating on the Commonwealth of Puerto Rico’s (PR) general obligation (GO) debt from ‘BBB-’ to ‘BB+,’ making it the first rating agency to downgrade the Commonwealth to below investment-grade levels. Just three days later, Moody’s cut its GO rating by two notches to ‘Ba2’; ratings that are capped by or linked to the Commonwealth’s GO rating were also downgraded two notches, with the exception of the Puerto Rico Aqueduct and Sewer Authority (PRASA) Revenue Bonds.

The moves were by no means a surprise. Puerto Rico’s economic contraction and fiscal decline has been persistent, well-documented and widely acknowledged within the municipal marketplace. Over the past decade the government has routinely employed non-recurring budgetary measures including the use of one-time bond proceeds to fund Commonwealth operations, both unusual for state-equivalent obligors and a clear sign of underlying credit weakness. Additionally, bond yields have been more representative of a distressed credit since mid-2013. While S&P’s move came first, and now followed shortly thereafter by Moody’s, we expect Fitch Ratings will take similar action in the coming weeks, despite moves by the current Administration to bolster liquidity and come closer to structural budgetary balance for fiscal year 2015.

At Columbia Management, we have acknowledged Puerto Rico’s credit challenges for a very long time — largely due to our opinion that there is no easy way for the government to spark economic growth and enact meaningful fiscal reform, as well as our understanding that a bailout from the Federal government has not been offered or considered. This is why we are very cautious when looking at our exposure to PR bonds.

Downgrade implications

While the move was widely anticipated as evidenced by the relatively benign market response, there are some credit implications the Commonwealth will face in the coming weeks. The downgrades have the potential to trigger an interest rate step-up for some notes outstanding, some of the Commonwealth’s swap transactions may be terminated and rollover risk on mandatory tender floating-rate bonds could be escalated — all pressuring current liquidity levels. The Administration’s ability to navigate troubled waters over the coming weeks and months, including the anticipated sale of sales tax obligation bonds later this month, will be important indicators of near- term credit stability.

Systemic risk

While market reaction to downgrades to this point has been muted, we think Puerto Rico remains a potential systemic market risk. PR is one of the largest issuers in the municipal market with more than $70 billion in outstanding debt across its issuing bodies (not including unfunded pension liabilities) and is widely held. By comparison, Detroit has less than $8 billion in outstanding debt. A future default or debt restructuring of some kind would likely do even more damage by rattling investor confidence in an asset class that has generally been seen as a bastion of safety. While the attributes of PR are not shared by the vast majority of other municipal issuers, the blow to investor confidence could likely impact all municipal market issuers.

Credit distinction important

While acknowledging the aforementioned credit challenges, given current depressed prices and positive financial measures to date, we believe that the opportunity costs of completely avoiding Puerto Rico debt may be substantial — especially since we believe some of the non-GO debt includes features that demonstrate investment-grade characteristics. The new administration has taken the positive and perhaps unexpected steps of raising recurring revenues, instituting cost controls, curbing borrowing, adopting comprehensive pension reforms designed to reduce cash flow pressures from growing pension obligations and reportedly fast-tracking an anticipated balanced budget for fiscal 2015 (staring July 1). When analyzing exposure to Puerto Rico, it is important to distinguish between credits that are supported by the Commonwealth’s general obligation or appropriation pledge and those secured by revenues independent of the Commonwealth’s general revenues.

Ultimately, we remain acutely aware of the many challenges Puerto Rico and its issuers face and, as such, we are constantly monitoring our exposure to these credits and the risks inherent therein. We maintain the opinion that investing in Puerto Rico municipal bonds remains appropriate only for investors who can tolerate rating and price volatility.

Disclosure

Standard and Poor’s rates the creditworthiness of municipal bonds, with 15 categories ranging from AAA (highest) to D (lowest). Ratings from A to CCC may be modified by the addition of a plus (+) or a minus (-) sign to show relative standing within the major rating categories.

The Moody’s bond rating scale goes from Aaa (highest) to C (lowest). If a rating is upgraded three notches by Moody’s for example, it goes from Baa to Aaa or Baa to C or lower in a downgrade.

 

Michael Taylor

Senior Municipal Analyst
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