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The Bond Buyer
Puerto Rican Downturn; Moody's Move Causes 'Circling' of Wagons
By Adam L. Cataldo
23 May 2005
Vol. 352, No. 32138
WASHINGTON -- Puerto Rico's downgrade to Baa2 from Baa1 by Moody's Investors Service late last week roiled the short-term market and could spell more difficulty for the fiscally challenged commonwealth. Its credit outlook is negative.
A $32 million block of Puerto Rico commercial paper with a weekly reset period initially offered at 3.05% Friday morning ended up trading at 3.35%, 37 basis points higher than The Bond Market Association Municipal Swap Index of weekly floating rates, which was reset at 2.98% last week.
"There's a lot of circling of the wagons," one West Coast-based fund manager said. "It's quiet just because people are trying to decide what to do."
The downgrade of Puerto Rico's short-term rating to MIG-2 is particularly relevant to money market fund managers. While it is technically the lowest rating at which they are still permitted to hold paper under Rule 2a-7 of the Investment Company Act of 1940, many funds have internal guidelines prohibiting it, which could put pressure on them to sell the commonwealth's paper.
"You'll probably see more and more of them come out for the bid as we get through next week, and I would expect the bid side to fade with every piece that comes out," the fund manager said.
Moody's cited the continued weakening of the general fund, an increase in tax supported debt, and a decline in liquidity by the commonwealth's Government Development Bank as driving factors behind the downgrade - which dropped Puerto Rico's long-term debt rating to just two-steps higher than junk status.
"The financial results for the last year have been much more negative than expected," Moody's analyst Tim Blake said. "The magnitude of the budget and financial problems has grown."
Blake said the downgrade is Moody's first ratings change on the commonwealth's GO debt in more than 25 years. The agency placed a negative outlook to the commonwealth's GO debt last September, and put a negative outlook on some transportation bonds about two years ago. Blake said Puerto Rico's downgrade was a result of a situation that has been deteriorating over the past two years.
"We are encouraged by the fact that the commonwealth officials recognize the seriousness of the budget problem, and recognize the necessity of stopping the cash burn immediately," Blake said. "Whether they will be able to do this we will have to see."
GDB president William Lockwood said the ratings action was not a surprise.
"Many of their concerns have to do with issues in fiscal '04 and beyond," Lockwood said.
For the last three years the GDB has made loans totaling $1 billion to the government to help balance the budget. That includes a $550 million loan for the current fiscal year. If a budget for the 2006 fiscal year is not passed by June 30, the commonwealth will operate under the previous year's budget.
Gov. Anibal Acevedo Vila took office in January. One of the problems in getting a budget passed is that the opposition New Progressive Party controls the legislature.
Lockwood said the next debt sale by a commonwealth issuer will be in about two weeks when the Puerto Rico Infrastructure Finance Authority comes to market with a $520 million deal.
Blake said the general fund's operating deficit for the current fiscal year is approximately $1 billion. The commonwealth's revenues will total $8.3 billion, an increase of about 5%. However, expenditures are projected at $9.3 billion, an increase of about 12%. The commonwealth's fiscal year begins on July 1.
"They were already in a structural gap in '04, and in '05 they have widened that structural gap by growing expenditures at twice the rate of revenue growth," Blake said.
In a January report, Moody's said the commonwealth faced a general fund gap in fiscal 2005 of as much as $800 million. A GDB spokeswoman said at the time the actual projected gap was about $993 million, with a real cash need of $443 million.
The commonwealth spends about $800 million per year on debt service payments, Blake said.
"They have been keeping it fairly flat through their refundings and restructurings," he added.
The full extent of the downgrade on the market remains to be seen.
"I don't know if there has been any real impact today," Paul Brennan, a portfolio manager at Nuveen Investments Inc. in Chicago, said Friday. "But I think the market was kind of trading ahead of Moody's. The outlook on Puerto Rico has been negative for a long time and the market has already had that priced in."
Nuveen owns some Puerto Rico debt, said Brennan, who manages funds worth about $8 billion combined.
The impact of the downgrade was muted somewhat because much of the commonwealth's debt is insured, Brennan said. With its GO debt already rated below A, Brennan said he did not think going to Baa2 from Baa1 would trigger a sell-off by bondholders.
"It does trade pretty well all things considered, they are exempt everywhere," Brennan said. "They are pretty liquid and they trade at a pretty tight spread for their rating, because there is such a huge amount of acceptance of that debt."
Fitch Ratings does not rate Puerto Rico. Standard & Poor's has the commonwealth's GO debt and its appropriation debt rated at A-minus.
Jacob Fine contributed to this story. (c) 2005 The Bond Buyer and SourceMedia, Inc. All rights reserved. http://www.bondbuyer.com http://www.sourcemedia.com