Puerto Rico – The Step Down

Standard and Poor’s rating service downgraded the general-obligation debt of Puerto Rico yesterday from the barely investment-grade rating of BBB- to BB+, citing continued economic weakness and an uncertain outlook going forward.

In addition to the downgrade of the Commonwealth itself, the rating agency also made the following ratings changes effective:

COFINA: unchanged (outlook negative)
COFINA Senior: AA-
COFINA Sub: A+
GO: BBB- to BB+
Public Building Authority: BBB- to BB+
Appropriation Credits: BBB- to BB
Pension Obligation Bonds: BBB- to BB
Government Development Bank: BBB- to BB
Highway Transportation Authority 98 resolution: BBB to BB+
Highway Transportation Authority 68 resolution: BBB+ to BB+
PR Infrastructure Financing Agency: BBB+ to BB+
PRASA (Aqueduct and Sewer Authority): BB+/Stable to BB+/CreditWatch Negative
PREPA: unchanged

All are on outlook negative. The rating agency also noted that the Commonwealth’s planned $2bn issuance this spring was factored into the ratings.

The immediate market impact was a quick 20-30 basis-point drop in the bid side of what Puerto Rico bonds we saw in the market.

There is clearly some additional headline/event risk now present in the market for Puerto Rico debt.

Some of the open questions are:

Will the planned $2 billion issuance – using more of the coverage from the existing sales tax – be enough to provide enough incremental liquidity to the Commonwealth while quelling the debt markets, which have seen yields rise 200–300 basis points or more on the Commonwealth’s or its agencies’ debt since early last summer?

Will this ratings change spur more bond fund redemptions? January has seen, for the most part, a resumption of bond fund inflows after what were mostly heavy outflows from June onward last year. The exception to this good news was municipal bond funds known to contain a high degree of Puerto Rico paper. Most bond funds – but not all – can make a decision to hold paper that was previously investment-grade but which drops below investment-grade. There may be some forced selling by funds.

Does this downgrade “up the ante” in terms of the Commonwealth receiving any sort of federal help? This help could possibly take many forms – from a “Brady Bond” configuration where there is some guaranty of principal by the United States to a structure similar to the Build America Bond structure, where there is a subsidy of interest payments by the US government. Some of this is speculation, as there is clearly not an appetite for any sort of “bailout” by the US Congress. But unlike Detroit (subservient to Michigan) and Stockton (subservient to California), Puerto Rico is a commonwealth of the United States, and Chapter 9 bankruptcy is not a legal option for the Commonwealth.

The one thing we do know is that the Commonwealth and its agencies have been TRADING as if they were below investment-grade since late last summer. Cumberland does not currently own any Puerto Rico obligations. But the importance of credit surveillance cannot be overstated.

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