The Commonwealth of Puerto Rico’s general obligation debt was lowered to below investment grade (BB+) by Standard and Poor’s on February 4, 2014. Inadequate liquidity and concerns about the Commonwealth’s ability to access the capital markets are the driving force behind S&P’s rating downgrade. The other rating agencies will likely downgrade the Commonwealth to below investment grade shortly.
In addition to liquidity concerns, the Commonwealth of Puerto Rico faces a stubbornly weak economy (negative GDP growth in every year since 2007), 14 consecutive years of budget deficits, significantly underfunded pension plans and an onerous debt level ($70 billion). The Commonwealth’s public pension funding level of 8% is far worse than any U.S. state (Illinois pensions are 45% funded). The debt level represents 90% of GDP which is higher than any state and extremely high for its population of 3.6 million.
The political questions surrounding the Commonwealth of Puerto Rico are also complex. Puerto Rico is a sovereign commonwealth; it is not a state or a city. There has never been a successful vote to begin the application for statehood in the United States. However, Puerto Rican residents do have U.S. citizenship status. There is no precedent regarding the legal status of a territorial jurisdiction like Puerto Rico seeking direct assistance and federal guarantees under these conditions. Puerto Rico has benefitted by many special tax treatment-related subsidies in the U.S. IRS code.
The overall market reaction to the downgrade has been muted, at best. By most accounts, investors were expecting the downgrade to occur and Puerto Rico debt has been trading at speculative levels since news stories began chronicling the mounting fiscal challenges for the Commonwealth during the summer of 2013. As an example, their general obligation bonds due July 1, 2039 have dropped 31 points from a price of $103.17 on May 31, 2013 to $72.29 as of January 31, 2014. However, following the downgrade news, the price level has held steady.
Going forward, the Commonwealth is expected to bring to market a sizable $1 billion or larger deal to plug their budget deficit, likely within the next two months. Although the deal has been announced, few details have been finalized. These details and the market’s response will ultimately determine whether further downgrades will occur. Because of the weak credit metrics and further downgrade risk potential, we do not view Puerto Rico credits as appropriate investments, except in those cases where insurers must meet state-deposit provisions.
Gregory A. Bell, CFA, CPA
Director of Municipal Bonds
Hugh R. McCaffrey, CFA
Senior Analyst, Corporate Credit