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Raters Giving Puerto Rico Some Leeway

SAN JUAN - Many people already consider the rating of Puerto Rico to be below investment grade, but rating agencies are giving the new governor's administration some time to take control of finances before acting to downgrade the credit, an investor said during a conference there last week.

"Many people have you at below investment grade. The rating agencies, I believe, are giving Puerto Rico and the administration the courtesy of, 'Let's see what these guys can do,' " said Rafael Costas, senior vice president and co-director of municipal bonds at Franklin Templeton.

Of Puerto Rico debt, the firm holds "approximately $1.4 billion across the complex of municipal bond funds," Costas confirmed via e-mail.

Costas, in his presentation on the credit, compared the commonwealth's fiscal state to a patient with stage-four cancer, who must undergo chemotherapy or radiation to overcome the illness.

"You're not alone in having to make decisions on reducing the size of government or increasing revenues," Costas said. It is "a painful cure that you're going to have to go through. Without it, you're probably going to lose your investment grade."

Investors and rating analysts at the conference hosted by the Government Development Bank for Puerto Rico, the commonwealth's financing agent, said Puerto Rico must take control of its finances and move towards structurally balanced budgets or face potential downgrades or outlook changes that would make it much harder to access capital.

Already the municipal market is experiencing some of the widest credit spreads, with low-level investment-grade credit having to pay 228 basis points more to borrow than gilt-edged credits, according to Municipal Market Data's yield curves last week.

Puerto Rico's general obligation rating stands at the lowest investment-grade level and a downgrade would push it into junk status. Coping with an ongoing three-year recession, a $3.4 billion deficit in its $9.48 billion fiscal 2009 budget, and an estimated contraction of the local economy by 3.4% in this fiscal year and 2% in fiscal 2010, scaling back on expenditures and increasing tax revenues will be a painful process, bondholders and analysts said.

Yet the commonwealth must reduce government spending even further and boost tax rates or implement fees to help balance its budget. This is the fifth consecutive year that Puerto Rico's recurring expenses have surpassed its recurring revenues, according to the GDB.

Standard & Poor's analyst Horacio Aldrete and Moody's Investors Service analyst Robert Kurtter decline to put a deadline on when Puerto Rico will need to show fiscal results in order to starve off a potential change to the GO rating, but both analysts said officials must address the $3.4 billion deficit.

Gov. Luis Fortuño last week said his administration will release its deficit-reduction proposal in two weeks. That plan will include a $1 billion to $1.8 billion reduction of expenditures, or 15% to 25%, and tax increases. The governor declined to say whether he would propose an increase in the island's 7% sales tax.

"Whether the economy is good or bad, some of these important initiatives need to be implemented, and the bottom line will be whether or not they are achieved," Kurtter told the audience of bond holders and investment bankers. "As to a timeline, and what are the triggers, when do we pull the trigger? We're trying to be as transparent as we can about the factors that we're looking at. Again, our approach is continuous."

Kurtter said Puerto Rico's current stable outlook on the rating indicates that "we don't at this point see any change on the horizon."

News reports over the weekend indicated that Standard & Poor's would actually downgrade the GO rating if officials did not take budget action by June 30. Aldrete disputed those reports.

"We don't have a set timeline, we're not looking at June 30 as any sort of countdown for them to take action," Aldrete told The Bond Buyer yesterday. "This is just a very fluid process and what is true, though, is that the size of the budget gap will require probably an equally significant level of response to that deficit and that the sooner that plan is crafted, the more flexibility the commonwealth is going to have to tackle that budget. Because if left unaddressed, this $3.4 billion deficit at the end of this fiscal year would only translate into an equal or greater deficit going into 2010."

Losing its investment-grade rating would limit Puerto Rico's access to the market, as many traditional investors cannot place junk bonds in their municipal portfolios. Costas said if the commonwealth fell below triple-B, he would be limited in placing Puerto Rico's bonds in the firm's $5 billion high-yield fund, which is much smaller than the company's approximately $60 billion municipal asset fund.

"Puerto Rico's now at the cusp of that [investment grade] and if it slips below that, I only have one fund, the high-yield fund, that can buy Puerto Rico debt," Costas said. "So you go from $60 billion that I can deploy and use to buy Puerto Rico [debt] to a $5 billion fund."

Rating change or not, investors are currently feeling the effects of doubts in Puerto Rico's GO bond quality. Joe Rosenblum, senior vice president and senior municipal credit analyst at AllianceBernstein LP, said the $1 billion of GO and commonwealth-backed bonds that his firm holds have dropped in value by $120 million.

"You have to also understand that our bonds get valued everyday," Rosenblum said. "So as the credit situation in the commonwealth deteriorates, the value of our bonds fall and that affects obviously the firm and more importantly the clients who have invested with the firm."

"For example, in the last year or so, we estimate that the bonds that we bought from Puerto Rico have lost about $120 million in value," he said. "So that's been a direct impact on our holdings and how our clients perceive us, and obviously it's tainted our perception about the commonwealth and about how much credibility it might have."

During the investment panel, bondholders urged government officials for more transparency and access to the island's finances.

Rosenblum pointed to examples such as California's monthly newsletter to municipal investors, which includes budget updates, New York's Web site that details the state's swap exposure, and New York City's release of multi-year budget plans and financial information to its bondholders.

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