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Moody's Investor Service Press Release
Moody's Assigns Baa3 Rating to $380 Million Issue From Puerto Rico Public Finance Corporation
June 26, 2003
Moody's assigns a Baa3 rating and stable outlook to Puerto Rico Public Finance Corporation's planned $380 million offering of Commonwealth Appropriation Bonds, Series 2003 A, B, & C. These bonds are offered in Puerto Rico only and are not US tax-exempt. The purpose of the issue is to refinance existing debt to generate debt service savings for the General Fund of the Commonwealth of Puerto Rico (with savings largely concentrated in fiscal 2004). The low investment-grade rating reflects the medium-grade credit position of the Commonwealth, whose general obligation bonds are rated Baa1 with a stable outlook; the limited, subject-to-appropriation nature of the Commonwealth's payment obligation associated with these current bonds; and the increasing reliance by the Commonwealth on appropriation-backed debt structures to meet a variety of capital and other financing needs. The rating also reflects the absence of substantive bondholder remedies in the event of any future failure by the legislature to appropriate sufficient funds for debt service, including no recourse to any underlying financed assets or projects.
The Commonwealth's medium-grade general obligation rating reflects the following factors:
* the island's established political and economic link with the US, which has been the foundation for economic expansion and growth in real income over the last two decades;
* resident income levels that nonetheless remain very low, on average, relative to the US mainland;
* financial operations that have been characterized by low reserves and a trend of operating deficits, reflecting the costs of implementing an extensive healthcare reform program and other spending pressures, and a revenue structure that has shown moderate sensitivity to economic slowing over recent years;
* a government debt load which is very high and growing relative to personal income, but remains manageable in terms of annual servicing burden within the government budget.
* a large and growing unfunded actuarial pension liability that is a significant long-term financial issue, and could also produce unexpected cash needs in the near-term.
This report provides summary commentary on the Commonwealth's general credit profile, including updated information since our last Analysis report dated August 2002. Please refer to the Analysis for more detailed trend statistics and commentary.
PFC BONDS ISSUED TO REFINANCE EXISTING DEBT
The $50 million Series A bonds are issued pursuant to 2001 Puerto Rico legislation authorizing the long-term public market refinancing of a portfolio of loans made by the Government Development Bank (GDB) to various Puerto Rico government departments, agencies and corporations. The underlying loans were made over a period of years to fund various capital expenditures and operating deficits, including the Commonwealth's General Fund deficit in fiscal 2001. The bonds are special obligations of PFC, payable and secured by installment payments anticipated to be made from annual budgetary appropriations by the Commonwealth on behalf of the respective loan portfolio borrowers. This is the PFC's third issuance of bonds under this authoriziation, following $2.5 billion of bonds sold in 2001 and 2002.
The $270 million Series B bonds will refinance outstanding PFC bonds issued in 1995 and 1996 to finance liabilities of the former Puerto Rico Maritime Shipping Authority, while the $60 million Series C bonds will refinance outstanding PFC bonds issued in 1996 to finance liabilities of the Commonwealth to various municipalities. These bonds also are special obligations of PFC, payable and secured by installment payments anticipated to be made from annual budgetary appropriations by the Commonwealth.
The Series A, B, and C bonds are issued under separate indentures. In each case, the legislature is not legally bound to make appropriations for the debt, and no substantive remedies are available to bondholders in the event of any future failure to appropriate by the legislature. There is no security interest or form of recourse to any financed assets or projects. However, Moody's believes the risk of future non-appropriation for debt service is primarily related to the Commonwealth's general financial condition and its desire to maintain market access for appropriation financing. The Commonwealth has used appropriation-based structures in the past for capital projects and other needs, and expects to continue to use such structures in the future. The PFC's outstanding debt is now approximately $4.3 billion, and there is a moderate amount of additional appropriation debt outstanding from other Commonwealth government entities.
While there is no debt service reserve fund associated with any of the current bonds, the risk from a delay in budget adoption by the legislature is mitigated by Puerto Rico law which provides for automatic continuation of the prior year's spending levels in the absence of a new budget, together with the approximately level debt service structure of each of the financings. However, to the extent that debt service is not level, there may be some budget-delay risk that will need to be covered by a letter of credit facility to be provided by the GDB (which is not rated by Moody's). The LoC could be drawn by the bond trustee if a budget is not passed, but may not be drawn if a budget is passed but does not include a sufficient amount to cover the debt service.
PUERT RICO ECONOMY ADJUSTING TO EFFECTS OF GLOBALIZATION AND SECTION 936 TAX CHANGE. RECENT YEARS' SLOW ECONOMIC PACE CONTINUES.
Puerto Rico's economy continues to adjust to powerful external forces, including the phase-out of Section 936 tax benefits available to US corporations operating on the island, which constitute a major portion of the island's manufacturing base. The ten-year phase-out is currently in its eight year, and while some US-owned manufacturers have downsized or left the island in recent years, others have continued to expand their operations by using alternate organizational and tax structures for new business lines. The tax change comes at the same time as increased global competition from countries in Asia and Latin America for jobs in labor-intensive/low-skill sectors, and a slow overall US and global economy. In Moody's view, the ultimate economic impact of the 936 phase-out is still developing. We note that the island has lost a net 30,000 manufacturing jobs, or roughly 20% of the sector's total employment over the past five years. Most of these are in low skill sectors such as textiles, apparel, food products, and electronics assembly. However, the important pharmaceutical sector has continued to see plant expansions and job growth in recent years, which is a positive sign of the island's ability to remain competitive in technical/high-skill sectors. We currently expect the island's economy to revive reasonably well with an eventual stronger pace of US recovery.
According to BLS, Puerto Rico experienced a 3% decline in private sector payroll employment during calendar 2002. The overall job loss was only about 1%, however, due to a greater than 4% increase in government employment. For the first five months of 2003, private sector employment was essentially flat compared to the year-earlier period. According to the Puerto Rico Planning Board, the island's gross product declined slightly in fiscal 2002, and is on track to record modest growth during fiscal 2003. These trends in large part reflect the continued weak pace of growth in the US and global economies.
The island's tourism sector has held up fairly well over the past year (excluding the Iraq conflict period). Although hotel occupancy rates and total visitor spending levels have not matched their prior peaks in fiscal 2001, these indicators did see a reassuring rebound in fiscal 2003 from a weaker fiscal 2002. Tourism still accounts for a relatively moderate share of the island's economy, and in our view has room for further growth. A moderate pace of new hotel construction activity continues.
MODERATE REVENUE AND SPENDING VARIANCES IN COMMONWEALTH'S FISCAL 2003 BUDGET
The Commonwealth's improved budgetary discipline of fiscal 2002 has carried over to fiscal 2003, with early identification of revenue variances, spending pressures, and remediation plans. Fortunately, the Commonwealth is not experiencing the kind of depressed revenue and budget gap problems seen by most US states. On a roughly $7.8 billion budget, total revenues are currently projected to be below original estimates by less than $100 million, while spending is running over budget by about $130 million. The Commonwealth will receive approximately $70 million this year from the federal government as part of the state fiscal relief package, and expects to identify additional revenue sources to close its budget gap. However, it does remain to be seen whether the moderate gap will be closed without resorting to some form of borrowing from the Government Development Bank to fund current expenditures, as was done in the past two years.
The fiscal 2004 budget calls for a 4.5% increase in General Fund spending (3% if compared to likely higher-than-budgeted actual spending in 2003). Primary areas of increased spending are health care, debt service, pensions, and education. The budget anticipates revenues equal to expenditures, and does not contemplate any significant addition to the General Fund's ending cash balance.
COMMONWEALTH INCREASES RETIREE PENSION BENEFITS, DESPITE VERY LOW SYSTEM FUNDING STATUS
The fiscal 2004 budget includes a $72 million increase in the General Fund's contribution to the pension system, to cover the cost of an increase in retiree benefits. At the same time, the system's funding status has suffered further deterioration over the past two years, due to the continued weak performance of the equity markets. The Commonwealth estimates the unfunded liability of the general employees plan as of June 30, 2002 to be in excess of $8 billion, with assets on hand covering less than 20% of the actuarial liability. The teachers plan is undefunded to a lesser extent. In recent years, the pension system has experienced cash flow problems and has had to borrow from a local bank to meet retiree payments. We would not be surprised if additional pressures of this type were to recur, perhaps requiring assistance from the Government Development Bank and/or the General Fund.
HEAVY TAX SUPPORTED DEBT BURDEN REFLECTS CENTRALIZED GOVERNMENT, INFRASTRUCTURE INVESTMENTS, AND DEFICIT BONDING. ANNUAL DEBT SERVICE REMAINS MANAGEABLE.
The Commonwealth has a heavy tax-supported debt burden that in part reflects its centralized government - with many functions assumed by the Commonwealth which are carried out by localities in most of the fifty states - and also the broad scope of the infrastructure development tasks it has undertaken. In recent years, the government has also generated, and bonded for, significant operating deficits in healthcare and other areas. The current ratio of tax-supported debt to aggregate personal income is about 50%, more than four times as high as the most heavily indebted of the fifty states. The ratio is affected by the low levels of personal income in Puerto Rico (per capita income is about one-third of the US average) and by the large absolute amount of government debt. At roughly $21 billion - excluding self-supporting enterprise debt, such as that of the Electric Power Authority - the Commonwealth has more outstanding tax-supported debt than all but three of the states.
The Commonwealth's annual debt service on general obligations and other debt paid from the General Fund currently amounts to some 12% of the annual budget. This does not include all tax-supported debt, particularly the substantial issues by the Highway and Transportation Authority and the Infrastructure Finance Authority that are paid from revenues accounted for outside of the General Fund. Annual debt service has remained in the manageable range due to the Commonwealth's ability to impose high local tax rates on individual and corporate incomes, given the absence of federal income tax on the island. The General Fund debt profile has also been restructured significantly in recent years, flattening the annual servicing requirements in the coming years, but also increasing total future debt service payments. Finally, the low interest rates of recent years have also aided the debt affordability.
The Commonwealth's stable rating outlook reflects our cautious optimism regarding the island's economy and the continued affordability of the government's high debt load. In addition, recent improvements in budgetary discipline and liquidity are expected to continue. Fortunately, the Commonwealth is not experiencing the kind of depressed revenue and budget gap problems seen by most US states, although it remains to be seen whether the gap will be closed without resorting to some form of borrowing from the Government Development Bank, as was done in the past two years. Finally, we would not be surprised to see new pressures emerge due to the low funding status of the pension system.
Copyright 2003, Moody's Investors Service, Inc. and/or its licensors including Moody's Assurance Company, Inc. (together, "MOODY'S"). All rights reserved.