NEW YORK -- Fitch Ratings has downgraded the Commonwealth of Puerto Rico's general obligation (GO) and related debt ratings to 'B' from 'BB-' and placed them on Rating Watch Negative.
Today's action on the GO rating results in a downgrade of the Puerto Rico Aqueduct and Sewer Authority (PRASA) senior lien revenue bonds to 'B' from 'B+' and maintained on Negative Watch. However, it does not affect Fitch's ratings on debt of the Puerto Rico Electric Power Authority (PREPA; rated 'CC', Watch Negative).
The downgrade and Negative Watch reflect elevated concerns regarding both the ability of the Commonwealth to execute a financing to bolster the liquidity cushion of the Government Development Bank (GDB), and thereby that of the Commonwealth, and the willingness to pay on the part of the legislature. These issues are clearly related, as Fitch believes that recent statements and actions by the legislature that would result in an abrogation of the Commonwealth's commitments to general government bondholders have increased the challenges to a successful Puerto Rico Infrastructure Finance Authority (PRIFA) financing and, at a minimum, are likely to result in an increase in already elevated borrowing costs.SECURITY
GO bonds are secured by the good faith, credit and taxing power of the Commonwealth of Puerto Rico. Strong legal provisions for GO debt include a constitutional first claim on Commonwealth revenues, including transportation-related and rum excise tax revenues that are dedicated to specific authorities and other bonds.KEY RATING DRIVERS
ELEVATED EXECUTION RISK:
The risk that the Commonwealth will not be able to execute a financing to bolster liquidity in the near term has increased in recent months. The financing was delayed due to challenges in securing workable legislative authorization. More recently there has been mounting concern about the legislature's support of general government bondholder security; there are now two different proposals in the legislature that would materially negatively affect bondholder interests.WILLINGNESS TO PAY AN INCREASING CONCERN:
Fitch believes that the Commonwealth has the capacity to make full and timely payments on its GO and related tax-supported debt. However, Fitch notes that willingness to pay, particularly on the part of the Commonwealth's legislature, has quickly become a significant concern. Calls for debt restructuring could increase further in the coming months as part of the debate surrounding tax reform and the fiscal 2016 budget, and thereafter in the campaigns for the 2016 elections.GDB LIQUIDITY CRITICAL:
Given the Commonwealth's very tight fiscal position, GDB liquidity in essence serves as the financial cushion for the general fund. The GDB's liquidity has deteriorated and is projected to decline further. As such, near-term action to increase GDB liquidity is critical.BUDGET IMPROVED, BUT CHALLENGES REMAIN:
Following a long history of significant budget deficits and a reliance on borrowing to fund operations, the general fund gap has been reduced considerably under the current governor. Fitch believes achieving and maintaining balance will remain challenging, including due to ongoing revenue underperformance and increased demands for debt service and pension funding in the budget for the coming fiscal year.TAX REFORM PRESENTS OPPORTUNITIES AND RISKS:
The above-average reliance on corporate taxes in the Commonwealth's current revenue system has been a credit negative, given the potential volatility and concentration inherent in these revenue streams. The legislature is now considering the governor's proposal to substantially revise the tax code to focus on consumption. The tax plan involves substantial risks in both passage and during the implementation period, which may extend over multiple years. Based on legislative reaction to the governor's proposal, it seems likely that the final version of the reform will have significantly different features.FINANCIAL FLEXIBILITY CONSTRAINED:
The Commonwealth's capital markets access deteriorated steeply in 2013, and the market available for the Commonwealth's debt remains limited. Reliable external market access in line with market norms is important to long-term stability.RATING SENSITIVITIESINCREASED GDB LIQUIDITY:
Fitch expects to resolve the Negative Watch based on the Commonwealth's ability to successfully arrange a sizable PRIFA financing in the coming months or otherwise bolster GDB liquidity.WILLINGNESS TO PAY:
Fitch will downgrade the rating immediately and significantly if legislation proposing to reduce protections afforded to GO and related tax-supported debt progresses in the legislative process or if there is other tangible evidence that the Commonwealth is considering the restructuring of general government debt.CREDIT PROFILE
The next two months will be critical for the Commonwealth. In addition to the fate of the planned PRIFA financing to improve liquidity, revenue and spending performance in fiscal 2015 and the progress of the governor's tax reform proposal and upcoming budget for fiscal 2016 will be significant.
The Commonwealth once again finds itself in need of significant external financing to support liquidity at a time of still dramatically reduced market access. The planned PRIFA transaction to address this need was originally scheduled for the first half of the fiscal year but was delayed due to numerous roadblocks in the legislature.
Legislation was recently finalized that increases petroleum taxes to support a PRIFA financing of up to $2.9 billion that would be used, in part, to pay off highway authority loans at GDB. As GDB currently has sizable loans outstanding to the Highways and Transportation Authority, a refinancing of this debt would meaningfully bolster liquidity. The PRIFA transaction is expected to have a GO guarantee.
The Commonwealth was able to execute a sizable GO financing in a similar position last year and has since made further progress towards budget balance. However, signs that the legislature may no longer fully support the administration's plan to achieve fiscal stability or its commitments to bondholders are a significant change from last year that could make the financing more difficult to execute. Fitch has also noted extensive discussions in the media advocating broad debt restructuring, another indication of potential deterioration in the Commonwealth's willingness to meet its debt commitments.
Earlier this month, a bill was filed in the legislature that seeks to amend the Commonwealth's constitution to reduce debt protections and allow debt restructuring. Earlier this week, a different proposal was introduced that would amend the Commonwealth's Internal Revenue Code to impose a large tax on the interest generated by bonds issued by Puerto Rico's public corporations and other government entities. Around this same period the legislature approved measures to enhance the marketability of the delayed PRIFA transaction, as well as initiatives to augment fiscal 2015 revenues in support of fiscal balance, sending mixed signals of intent to the market. However, the introduction of two specific proposals in opposition to general government bondholder interests in a short time frame is a key factor in the downgrade to 'B'.
The Commonwealth has a complex debt structure including GO, sales tax, guaranteed, and public corporation debt. The often-cited figure for Puerto Rico's public debt of $71 billion includes not only debt supported by Commonwealth tax revenues but also debt of the electric and water and sewer utilities and other revenue-supported debt that is not the obligation of the central government. GO and GO-guaranteed bonds equal about 25% of total public sector debt as reported by the Commonwealth and sales tax-backed COFINA debt another 20%.
Puerto Rico's bonded debt levels and unfunded pension liabilities are very high relative to U.S. states, though less so when viewed in an international context. A large amount of outstanding debt has been issued for deficit financing purposes. Pension funding will remain exceptionally low even with the significant pension reform effort undertaken by the current administration, and the teachers system is projected to deplete its assets in 2020 in the absence of further reform.
The Commonwealth's general fund revenues are 2.4% ($122 million) below forecast through February, with expenditures reportedly in line with forecast. Thirty-six percent of annual general fund revenues are projected to come in from April through June when the ability to take offsetting action is limited, and last year April revenue performance was well below estimates. As a result, the cushion provided by GDB is particularly important.
Extensive tax reform proposed by the governor in February has proven controversial and political risk is significant. Consistent with expectations, the governor's proposal would focus taxation on consumption by imposing a value-added tax designed to generate substantial additional revenues, including by reducing tax evasion, and support economic growth. At the same time, the governor would reduce income tax rates, eliminate the gross receipts tax, and include reimbursements for lower income levels. The proposal is currently being considered by the legislature, and based on recent comments by legislative leadership it appears that any enacted tax reform will differ from the governor's proposal.
Fitch has noted the risk of the heavy budget reliance on a relatively small number of companies in the current revenue system and the high degree of tax evasion, but the reform involves numerous risks in both passage, with the possibility of politically motivated exemptions watering down its effectiveness, and implementation, with a poor Commonwealth track record in making such changes and estimating their results.
Puerto Rico's economy has been in recession since 2006, and performance remains weak. Fitch believes that the ultimate success of efforts to put the Commonwealth's finances on a sustainable path will be dictated by the performance of the economy, while at the same time efforts to reform public finances could support economic development.
Puerto Rico's status as a Commonwealth of the U.S. and strong linkages to the U.S. economy are credit strengths. Federal transfer payments represented 25% of 2013 personal income, mostly in the form of entitlements such as social security and Medicare. This serves as a stabilizing force but is also illustrative of the comparative weakness of the overall economy.COMPLETE LIST OF AFFECTED CREDITS
With today's action, Fitch has downgraded and placed on Rating Watch Negative all of the following ratings:
--$13 billion Commonwealth of Puerto Rico GO bonds, downgraded to 'B' from 'BB-'
--$6.7 billion Puerto Rico Sales Tax Financing Corporation (COFINA) senior lien sales tax revenue bonds and $8.5 billion COFINA first subordinate lien sales tax revenue bonds, downgraded to 'B' from 'BB-'
COFINA bonds have a security interest in and are payable from the Commonwealth's sales and use tax. COFINA is an independent governmental instrumentality of the Commonwealth and affiliate of the GDB established by specific legislation. The COFINA bonds are rated at the level of the Commonwealth's general credit. Although COFINA bonds were specifically excluded in the Public Corporation Debt Enforcement and Recovery Act, the passage of the Act substantially increased Fitch's assessment of the risk that the Commonwealth may take steps to the detriment of COFINA bondholders if the Commonwealth considered that a fiscal emergency and its need to provide essential services required legislative action limiting revenues available to COFINA. Fitch does not place COFINA debt below the Commonwealth's GO as the agency believes that if circumstances warranted a shift in COFINA revenues to fund the general government, the GO bonds would be equally likely to default. There is no rating distinction between the senior and subordinate COFINA liens, as the legal security of each would warrant a higher rating in the absence of Commonwealth risk factors.
--$2.9 billion Employees Retirement System ommonwealth of Puerto Rico (ERS) pension funding bonds, downgraded to 'B' from 'BB-'
The ERS bonds are a limited, non-recourse obligation of the pension system, payable from and secured by a pledge of statutorily required employer contributions to the system. The rating on the ERS bonds is the same as that assigned to the Commonwealth's GO bonds, as the Commonwealth is the largest employer contributor and contributions have a strong legal priority. Given that GO bondholders have a legal claim on Commonwealth revenues senior to contributions due to the pension systems, the rating on the ERS bonds can be no higher than the Commonwealth GO rating.
--$1.4 billion Puerto Rico Public Building Authority (PBA) government facilities revenue bonds guaranteed by the Commonwealth and rated by Fitch and $658 million PRASA Commonwealth guaranty revenue bonds, downgraded to 'B' from 'BB-'
Bonds of the PBA and PRASA that are guaranteed by the Commonwealth are backed by the Commonwealth's commitment to draw from any funds available in the treasury. The good faith and credit of the Commonwealth is pledged to any such deficiency payments, resulting in a rating that is the same as the Commonwealth's GO bonds.
--$3.4 billion PRASA senior lien revenue bonds, downgraded to 'B' from 'B+', Rating Watch Negative maintained
PRASA's revenue bonds likely will be influenced by movement of the Commonwealth general obligation rating for the foreseeable future given the Commonwealth's historical actions and ability to expose PRASA to potential fiscal and operational challenges.