MuniLand: Puerto Rico’s Pattern Behavior

A clear pattern has emerged in how Puerto Rico accesses the capital market. It goes something like this: propose new revenue increases, propose reforms, entice the capital markets with triple tax exemption and increase short-term liquidity…spend liquidity reserves. Propose new revenue increases, propose reforms, entice the capital markets and increase short-term liquidity…spend liquidity reserves. Propose new revenue increases, reverse reforms and draw down short-term liquidity. Wait, the pattern changed.

Last week Puerto Rico general obligation bondholders received disappointing news. The Puerto Rico Corporation Debt Enforcement and Recovery Act (the Recovery Act) was struck down as unconstitutional. For years, the Recovery Act empowered public corporations like the electric and water authorities to reorganize and restructure their debt. Prior to the Recovery Act, no mechanism existed for restructuring the public corporations. The Recovery Act dug a moat around the GO and Governmental Development Bank (GDB) debt and left the public corporations in a precarious position.

What is going on now that the moat is drained? Well, the initial reaction is positive for public corporation debtholders because the public corporations need to seek alternatives to restructuring, such as rate increases or collecting unpaid bills from the central government. The credit rating agencies took a decidedly negative view of the ruling. All lowered their rating on Puerto Rico’s GO, sales tax and public corporation debt. COFINA, or sales-tax-backed bonds, the last of PR’s investment grade rate debt, were downgraded to B from BBB by S&P. Fitch downgraded the GO to BB- and lowered its rating on the Aqueduct and Sewer Authority to B+. All of these ratings reflect highly speculative grade bonds.

Downgrades are another warning sign that Puerto Rico’s governmental and public corporation debt have become increasingly risky investments. At the same time, Puerto Rico is proposing a value added tax (VAT) of 16% to replace its existing sales tax. If the VAT proposal is promulgated into law, it is estimated to generate an additional $1.5B in new tax revenue. While a VAT has its merits, it is highly unlikely the tax could be implemented quickly and seamlessly, or could generate the estimated revenue. The VAT proposal is more of the same pattern we’ve seen in the past: propose new revenue increases, propose reforms, entice the capital markets with triple tax exemption and increase short-term liquidity. However, because of the severity of Puerto Rico’s credit crisis, events to come are unlikely to follow the same old script.

Sources: Bond Buyer, S&P Ratings, Fitch Ratings, Bloomberg News, WSJ, SNWAM Research