Puerto Rico said it would issue general obligation bonds in its upcoming sale, shifting from earlier indications that the debt would be backed by sales tax revenue.
The GO bonds will refinance obligations and address liquidity concerns, the government said in a press release Tuesday that named Barclays, RBC Capital Markets and Morgan Stanley as lead managers.
The announcement came just before Fitch Ratings cut the commonwealth's GO and related ratings to BB from BBB-minus, joining Standard & Poor's and Moody's Investors Service, which had cut the island's debt to junk last week. The rating agencies expressed concern over Puerto Rico's liquidity and faltering economy.
In early January Government Development Bank of Puerto Rico chairman David Chafey told The Bond Buyer that the government would sell a bond by the end of February and that it would probably be a Puerto Rico Sales Tax Corp. (COFINA) bond. On Monday night Gov. Alejandro García Padilla suggested that he might propose replacing the island's sales and use tax.
"Sales tax revenues have not been coming in as strong as expected," Janney Capital Markets managing director Alan Schankel said in an email. "The base expansion put into place this year was initially estimated to increase annual sales- and-use tax revenues by 25%, but through seven months the gain is closer to 5%-6%, leaving a smaller COFINA 3rd lien revenue stream, meaning lower borrowing ability.
"Presumably a COFINA 3rd lien would be rated below the Baa2 rating of the current sub-lien," Schankel added. "Sub-COFINA have been trading at similar levels to similarly structured GOs so far this year, so presumably a third lien would trade at higher yields than GO."
Sources close to the island's financing efforts said the commonwealth may have chosen to issue GO bonds instead of COFINAs due to the sheer amount of debt that could be issued through a GO offering. The price differential between the higher-rated COFINAs and GOs was not enough to outweigh the benefit of raising more total capital, a source involved with preparing the deal said.
The choice to issue GOs means the territory will have to offer very high yields to draw in investors following the trio of downgrades this month, traders said.
"Demand just depends on where it's priced," one New York City trader said. "If it's attractive enough there will be buyers but if it's priced like a normal GO, it's not going to sell; it won't get done. For them to bring a deal now with a credit that's lesser than the [Puerto Rico Electric] Power Authority bonds in August, it's going to be over 8% on the long end at least."
RBC Capital Markets and Morgan Stanley will serve as joint senior managers with Barclays running the books. "We have completed significant measures in the past month to improve our fiscal health and are ready to access the market with a new issuance of GO bonds," Chafey said.
Officials promise to provide more information in a webcast that has been rescheduled for 2 p.m. on Feb. 18. To clear the way for the bond sale, García Padilla asked the Puerto Rico legislature to approve bond sales of up to $3.5 billion.
In another sign of the government's skepticism of its own sales-and-use tax, the governor hinted that he might at the end of this year suggest the sales and use tax be replaced.
"We will also continue studies now under way so that within a year we can propose a new tax structure, one that will lead to a better balance among all sectors and promote economic development," García Padilla said. "These studies will include looking again at the [sales-and-use tax] in order to determine whether it's the best alternative for everyone, while taking into account the debt that the income from the [sales-and-use tax] guarantees."
The sales-and-use tax started in 2006, replacing a general excise tax. Some have said the tax is subject to high levels of evasion.
However, "replacing the current sales and use tax with a valued-added tax will raise myriad legal issues regarding the security for the COFINA bonds," Axios Advisors managing partner Triet Nguyen said on highyieldmunicipals.com.
In other news the GDB announced that Puerto Rico's economic activity index was down 1% in December compared to November. That followed monthly increases of 1.1% in September, 0.6% in October and 0.05% in November.
From November to December, non-farm employment rose 2.8% and gas consumption advanced 0.9%. However, cement sales plunged 15% and electric power generation fell 2.6%.
Non-farm employment has increased every month since August and is now up 4.4%.
The December index value was down 5.2% from December 2012.
Fitch has a negative outlook on the ratings, which suggests the direction the rating may move in the next year or two. The downgrade does not affect COFINA bonds.
Fitch also downgraded to BB from BBB-minus the commonwealth-guaranteed Public Building Authority revenue bonds, the commonwealth-guaranteed Puerto Rico Aqueduct and Sewer Authority revenue bonds, and the Employee Retirement System pension funding bonds.
Fitch managing director Laura Porter and senior director Karen Krop pointed to the government's reduced financial flexibility as the key factor in prompting the downgrade. The government has not been able to sell long-term bonds to take out short-term financing this past year. Since March buyers of Puerto Rico securities on the secondary markets have been asking for higher yields, they said.
The downgrades by Standard & Poor's and Moody's Investor's Service have required the government to prepare to make certain liquidity payments in the next few months, the analysts said. In the context of the commonwealth's weak economy and elevated liability levels, "Fitch believes that these additional hurdles preclude the commonwealth maintaining an investment-grade credit profile."
The analysts also said the government has worked quickly and decisively to address its fiscal challenges. Puerto Rico's pledge behind its GO is unusually strong, they said.
Fitch's maintenance of the current rating level assumes that the commonwealth will be able to sell a large bond in the near future to improve liquidity, that the economy will stabilize, and that the government will continue to achieve its budget targets.