Bates Research - 02-13-14

Puerto Rico Downgrades Continue

After our post was published last 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/Fitch), but moved the island down two notches Friday to Ba2 (equivalent to BB under S&P/Fitch'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 was mixed, and while the 'two out of three' requirement mentioned in the previous post has now been breached, there were not been sharp declines in either prices or index levels.

On Tuesday of this week, Fitch joined the other two rating agencies, and moved Puerto Rico below investment grade, from BBB- to BB (a two-notch move).   While the island had been under review by Fitch since last November, the move can be largely seen as related to the other downgrades.  Fitch noted in their announcement that "Recent downgrades have triggered new liquidity requirements and lowered expectations for the market available for the commonwealth's debt going forward, though there have been no significant negative developments regarding the commonwealth's finances or economy since November."

The market reaction to this news so far has been muted, with the S&P Puerto Rico Muni Index closing Thursday at 157.58, up 0.48% from the Tuesday close of 156.82. 

In 2010, an almost identical pattern of downgrades played out related to Greek debt, but with a drastically different market response.  On April 27, 2010 S&P moved first in that instance as well, moving Greece three full notches from BBB+ to BB+ (they moved Puerto Rico from BBB- to BB+, only a single notch move, with the other two rating agencies moving Puerto Rico down two notches.)  The news caused spreads on Greek bonds to widen, while other markets experienced stress as well: the Euro fell against the Dollar, and equity indices for Europe, Spain, and Portugal all declined 3% or more.  Moody's again moved second, though after a much greater period of time than with Puerto Rico.  On June 14, 2010 Moody's took Greece down four notches, from A3 to Ba1 (or from A- to BB+ using the S&P/Fitch scale).  Markets reacted poorly to the news again.  Fitch ultimately followed in January of 2011, taking Greece down to BB+ from BBB-. 

The Greek downgrades were sudden (in terms of the number of notches moved) and met with far more reaction from the market.  One possible explanation for the difference in reaction (amongst many, including the fact that the global economy was not as strong then as it is today), could be the political resolve within the country to become fiscally sound.  Greece was slow to adopt reforms and suffered leadership changes and civil unrest, whereas Puerto Rico has been quick to act and has done so with more unity.  Again, even the statements made in the wake of the downgrades echo this, with Fitch adding that "Puerto Rico’s current management has repeatedly shown its ability and willingness to take quick action to address financial challenges and external market concerns, much of which has required legislative action."  Moody's commented that “the administration has taken strong and aggressive actions to control spending, reform the retirement systems, reduce debt issuance, and promote economic development."  S&P made this statement during their announcement:

"That the rating is not lower is due to the progress the current administration has made in reducing operating deficits, and what we view as recent success with reform of the public employee and teacher pension systems, which had been elusive in recent years.  We view the reform as significant and could contribute to a sustainable path to fiscal stability."

With so much recognition, it is no wonder that government officials in Puerto Rico have reacted negatively to the downgrades.  Treasury Secretary Melba Acosta Febo and Government Development Bank for Puerto Rico (GDB) Chairman David H. Chafey have been jointly commenting on each downgrade.  In a statement released February 4th, they said, “While we are disappointed with Standard & Poor’s decision, we remain committed to the implementation of our fiscal and economic development plans.  We believe the investment community will recognize the positive impact of the reforms that the Garcia Padilla Administration has enacted in due course."  Their reaction to the next downgrade was more forceful: "We strongly disagree with Moody’s decision, and we will not relent in our plans to strengthen our fiscal situation."  Their reaction to Fitch's decision was back to "disappointed". 

Investors may be putting off any buy or sell decisions until after the February 18th quarterly webcast, where officials will discuss the downgrades, the territory’s current economic status and its outlook for placing new debt.  The commonwealth remains upbeat about its first return to capital markets since last August, naming Barclays, RBC and Morgan Stanley as its lead underwriters for the new issue. 

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