Recently, the commonwealth of Puerto Rico’s credit ratings were downgraded by each of the three rating agencies to “below investment grade” status. This is significant, since no other state or state-equivalent territory of the U.S, carries a below investment grade credit rating.
The downgrades by Standard & Poor’s (S&P) and Moody’s Investors Service (Moody’s) had the largest ripple effects in the municipal bond market. S&P downgraded Puerto Rico’s general obligation (GO) bonds and other bonds linked to the commonwealth’s GO bonds to “BB”. While Moody’s downgraded Puerto Rico’s GO bonds and related GO credits to the below investment grade rating of “Ba2”.
Sources: S&P, Moody’s and Fitch.
True Budget Balancing Act
Puerto Rico’s government leadership faces a true “budget balancing” act (no pun intended) in the very near term. Before the rating agency downgrades, the commonwealth was already facing a budget deficit of $650 million. However, the downgrades triggered an additional $940 million of liquidity requirements related to contingent claims on collateral. Other variable rate demand notes, puts and debts maturing by the end of 2015 total over $1.9 billion – bringing the commonwealth’s near-term liquidity requirement to around $3.5 billion.
S&P’s rating actions seemed more focused on the commonwealth’s liquidity and ability to access the capital markets, and Moody’s rating actions appeared more tied to concerns about the health of the commonwealth’s economy. A closer examination of the commonwealth’s debt metrics as compared with U.S. states clearly shows Puerto Rico as an outlier.
1. Source: Moody’s 2012 State Debt Medians Report dated May 22, 2012
2. Bureau of Business & Economic Research, as of 2013
3. Source: Commonwealth October 2013 Operating Report (p23)
4. Note: Puerto Rico citizens are exempt from paying federal taxes
Tough Decisions Intended to Make a Meaningful Dent
To assist in achieving a balanced budget, Puerto Rico’s leadership has demonstrated strong political will by restructuring its state employee pensions, including freezing benefits under defined benefit plans for employees in the public pension system who have not yet retired, increasing retirement age and raising required employee contributions to the system. Likewise, the commonwealth has enacted a similar restructuring to its Teacher Pension Program. Currently, this restructuring is being contested in the Puerto Rico Supreme Court. In addition, the commonwealth has reduced employee headcount chargeable to the general fund by 8%. Also, the Office of Management and Budget has been empowered to reduce authorized reductions by $170 million, which would make a meaningful dent in repairing future budget deficits.
Off to a Good Start … Will the Market’s Appetite Hold Up?
At present, Puerto Rico’s short-term bonds are trading at a higher yield than longer maturing bonds. Investors are weighing the trade-off between bond coupon and bond price, as they demand a higher yield for a higher dollar price. Both traditional and non-traditional municipal market bond investors are anticipating the new debt offering that Puerto Rico is expected to bring to market in March 2014 – about $3.5 billion of its tax-exempt GO bonds. The looming question is: “Does the market have the appetite?” A $3.5 billion bond financing should, in theory, allow the commonwealth to meet its near-term liquidity requirements and give the commonwealth more time to work on implementing a structurally balanced budget.
Based on its recent actions of raising general fund revenues by improving budget estimating efforts, while simultaneously reducing expenses related to pension contracts and staffing levels, the commonwealth is off to a very good start to improving its financial performance, at the midway point in fiscal 2014. It is quite possible that the commonwealth will be able to achieve its goal of a structurally balanced budget infFiscal 2015, if its leadership continues to exert its political will and find new ways to generate general fund revenues, while keeping expenses in line. Given this possibility, investors looking to own Puerto Rico bonds may be well served to purchase the new issue bonds with short-term maturities.