Bates Research - 02-07-14
Puerto Rico Downgrade
On Tuesday, S&P downgraded Puerto Rico below investment grade from BBB- to BB+. The island had previously been placed on watch by S&P for a possible downgrade on January 24th. In a call following the rating announcement, S&P analyst David Hitchcock indicated that Puerto Rico is still on negative watch for further downgrades, and a failure to find buyers for its anticipated bond issue by the end of February could trigger another cut. The move to downgrade now, while Moody's and Fitch have been waiting to see the results of Puerto Rico's latest bond issue, may have been caused by inside information about liquidity from the Government Development Bank in Puerto Rico. The primary reasons given for the downgrade were the finances of Puerto Rico, and specifically the impact of its inability to tap capital markets on liquidity. All securities were effected, except those issued by the Sales Tax Finance Corp. (COFINA), which are still on negative watch.
Press reports have speculated that the downgrade would cause a selling wave from institutional holders of Puerto Rico's debt, citing a requirement that they hold investment grade securities. This has not been the case, as most operate under a 'two out of three' requirement, meaning that as long as Fitch and Moody's take no action, the securities may still be held. The move will, however, have a negative impact on the island's finances because many of its obligations carry a penalty for falling below investment grade, the payout on which could amount to $940 million according to S&P's estimates.
Trading in Puerto Rico securities in the aftermath of the downgrade seems to be unaffected, with prices on some bonds even rising. Many market participants have indicated that the effect of the downgrade was already priced into the bonds, leaving the market unsurprised at the actual event, and eager to move forward. A look at the performance of the S&P Puerto Rico Muni Index illustrates both these points, with a lack of movement after the announcement suggesting a general lack of surprise, and the decline of approximately 20% since the beginning of 2013 suggesting the downgrade was already priced in (see Chart below). On February 4, the day the downgrade was announced, the Index closed at 157.54. The next day it closed down just -0.27% at 157.12, and Thursday it rebounded above its pre-downgrade level to 157.57.
Hedge Funds and other alternative investment vehicles seem to be waiting for even lower prices before they begin buying up the bonds in large quantities, so there may be further price support still waiting in the wings as well.
For more background on the situation in Puerto Rico, click here.
UPDATE: After this post was published on Friday the 7th, Moody's joined S&P in downgrading Puerto Rico below investment grade. Moody's had previously rated Puerto Rico Baa3 (equivalent to BBB- by S&P), but moved the island down two notches Friday to Ba2 (equivalent to BB under S&P's rating methodology). In making its decision, the rating agency cited a high debt load, high fixed costs, and low available liquidity, with constrained access to capital markets. Ultimately it concluded that while “some economic indicators point to a preliminary stabilization, we do not see evidence of economic growth sufficient to reverse the commonwealth's negative financial trends." Market reaction has been mixed, and while the 'two out of three' requirement mentioned above has now been breached, there have not been sharp declines in either prices or index levels.