S&P Downgrades Puerto Rico to Speculative Grade

Standard & Poor's downgraded Puerto Rico's general obligation bonds to speculative grade Tuesday, citing the commonwealth's limited liquidity.

The rating was cut one notch to BB-plus from the lowest investment grade rung of BBB-minus. It remains on watch negative.

"This is certainly not a surprise," said Janney Capital Markets managing director Alan Schankel. "I believe the lower rating has been well built into prices, and although I would anticipate some negative price movement, I do not expect a precipitous drop in valuations."

In addition to its action on Puerto Rico GOs, S&P dropped its rating on long-term debt of the Government Development Bank of Puerto Rico to BB from BBB-minus and dropped the GDB's short-term rating to B from A-3.

S&P downgraded various bonds from the Puerto Rico Highways and Transportation Authority to BB-plus. The agency lowered the commonwealth's appropriation secured and Employee Retirement System bonds to BB from BBB-minus.

It did not change its rating on the Puerto Rico Sales Tax Finance Corp. (COFINA) bonds, rated A-plus and AA-minus, depending on the lien.

All ratings except for those for the COFINA bonds, remain on negative watch. S&P has a negative outlook on the COFINA bonds.

S&P analysts David Hitchcock and Horacio Aldrete-Sanchez noted the Puerto Rico's government's reforms of its three central pension systems, its steps to reduce its deficit and its promise in the last few days to propose a balanced budget as positives for the credit.

However, these are long-term positives, they said, in contrast to more immediate concerns about liquidity.

In a webcast Tuesday afternoon, Hitchcock indicated he recently received information about liquidity at the GDB and/or in the government proper and that he felt compelled to act quickly to communicate the lack of liquidity to the investor community through downgrades to both entities. The lack of liquidity is an issue for the coming year, while the steps the government has taken or may take will help over a longer time frame, Hitchcock said.

"While we believe [a near-term bond] sale would provide temporary liquidity into fiscal 2015 and could be an important stabilizing factor, we believe there remains implementation risks over the next year in light of continued economic weakness," Hitchcock and Aldrete-Sanchez wrote. "In our view, there is little margin for error over the next two years in [the government's] plan to reduce operating deficits, and potentially difficulty financing future deficits larger than currently projected by the commonwealth."

Puerto Rico Treasury Secretary Melba Acosta Febo and GDB Chairman David Chafey said the fiscal and financial leadership of the Puerto Rico government will hold a webcast on Feb. 12 to discuss the impact of the downgrade and the commonwealth's fiscal and economic plans and progress.

"We are proceeding with focus and determination to continue strengthening the commonwealth's financial position and build a solid foundation for economic prosperity and development," they said in response to S&P's action. "We are confident that we have the liquidity on hand to satisfy all liquidity needs until the end of the fiscal year, including any cash needs resulting from today's decision."

The S&P analysts estimate that their downgrade to speculative grade will cost Puerto Rico's government $940 million in the forms of debt acceleration and interest rate swap collateral posting.

Since December 2012, when Moody's Investors Service downgraded Puerto Rico to Baa3, Gov. Alejandro García Padilla has taken a number of steps pleasing to bond analysts.

He has adopted a budget with a smaller deficit. He has encouraged the water and sewer authority to raise rates to make it self-sustaining. He has developed new sources of income for the highways and transportation authority so that it will regain financial stability. And he has instituted a major reform of the government's primary pension system to prevent it from running out of money in the future.

However, the economy has been weak and the unemployment rate has gone up in recent months.

Interest rates on the commonwealth's bonds have soared since May on the secondary markets. In late summer skeptical stories about Puerto Rico's bonds in Barron's and Forbes contributed to a further increase of the island's yields in the secondary market.

Moody's and Fitch Ratings still have Puerto Rico at the lowest investment grade rung.

In late November Fitch put Puerto Rico's GO rating on review for a downgrade.

In December Moody's put Puerto Rico's GO rating on review for a downgrade. S&P followed in late January.

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