Woes Continue for Puerto Rico Bond Holders
First, unemployment rates in Puerto Rico have continued to climb since June of this year, topping out at 14.7% in October, the most recent data available. To put that number in perspective, this is almost double the current national average of 7.3%, and almost 50% higher than the U.S. national average was at its worst during the recession in 2009, which peaked at 10% in October 2009. That level of unemployment both dramatically increases the draw on public funds through various support programs while simultaneously reducing government income from taxes. The fact that this unemployment is rising at a rate of .3% per month on average for the last five months indicates that Puerto Rico might fall further into a recession.
At the same time, Moody’s Investors Service recently put $52 billion worth of Puerto Rico’s outstanding bonds under review for a downgrade to junk bond status. This includes all Puerto Rico bonds currently outstanding with the limited exceptions of bonds backed and/or issued by the Puerto Rico Electric Power Authority and the University of Puerto Rico. Currently, Moody’s carries a rating of Baa3 for Puerto Rico’s general obligation (“GO”) bonds, as well as nine other public sector bonds and notes. As a result, if the review results in a downgrade, this will necessarily push all of those bonds into speculative or “junk” ratings.
This review also includes a number of other bonds, such as:
• Bonds issued by the Sales Tax Financing Corporation of Puerto Rico (“COFINA”), which is currently rated at A2 for the senior lien bonds and A3 for the junior ones;
• Revenue bonds issued by the Puerto Rico Highway and Transportation Authority highway, currently rated at Baa2;
• Public Finance Corporation Commonwealth Appropriation bonds, currently rated at Ba1;
• Puerto Rico Aqueduct and Sewer Authority Revenue bonds, currently rated at Ba1;
• Puerto Rico Highway and Transportation Authority subordinate transportation bonds, currently rated at Ba1.
These bonds might easily end up with junk bond ratings as a result of this review.
According to Moody’s, the review was ordered because of a combination of factors, including the rise in unemployment in Puerto Rico, as described above, a negative outlook for projections of Puerto Rico’s economic growth, shrinking liquidity at the Government Development Bank, and the fact that Puerto Rico has not accessed the bond market for a long time, which might indicate that it has been priced out of the market.
The shrinking liquidity refers to events like Puerto Rico’s decision to pay off a bond anticipation note held with Barclays in full, rather than attempt to extend the note under a new rate. This cost the government $400 million in cash, which significantly reduces the islands free cash flow for other potential problems. Similarly, Moody’s has concluded that a number of financial systems that Puerto Rico has in place, including swaps and other variable rates as well as acceleration provisions, will result in a liquidity demand of up to $1 billion on Puerto Rico in the event its bonds get downgraded to junk status, which seems more and more likely to occur.
The negative projections for Puerto Rico’s economy refers to the fact, at least in part, that Puerto Rico was over 9% shy of its projected revenue for the month of November. While the net revenues for the last five months are still around 2.5% above projections, the drop in revenue for November could be a sign of serious trouble.
It is similarly disconcerting that Puerto Rico has not attempted to sell any new bonds in many months, as it could be an indication that it simply cannot. Puerto Rico may believe, based upon the recommendations of companies such as UBS which normally underwrite Puerto Rico’s bonds, that the market would demand such a large risk premium to purchase its bonds that Puerto Rico would be unable to afford the costs. Essentially, investors in the open market would be saying that they believe an investment in a Puerto Rico municipal bond is so high risk that they will only buy it if the interest rate is well above market rates for other municipal bonds. Just like an individual that can’t afford a mortgage on the house if the best interest rate a bank will offer them is 25%, Puerto Rico may not be able to afford the interest rates that it would have to pay to borrow more money.
All told, the news that Moody’s was initiating this credit review was enough to drive Puerto Rico bond prices lower by itself. If Moody’s ultimately does downgrade some or all of these Puerto Rico bonds, prices will inevitably fall even further. These drops will be even more shocking if it puts Puerto Rico bonds into junk bond status, as it may force a number of investment companies to sell off its Puerto Rico bonds at fire-sale prices, or it will at least prevent many such investment companies from buying up any shares outstanding.