Fitch Ratings has downgraded the ratings of variousCommonwealth of Puerto Rico bonds as follows:--$13.4 billion Commonwealth of Puerto Rico GO bonds to 'BB-' from 'BB';--$6.7 billion Puerto Rico Sales Tax Financing Corporation (COFINA) senior lien sales tax revenuebonds to 'BB-' from'AA-';--$8.5 billion COFINA first subordinate lien sales tax revenue bonds to 'BB-' from 'A+';--$2.9 billion Employees Retirement System of the Commonwealth of Puerto Rico (ERS) pensionfunding bonds to 'BB-' from 'BB';--$3.4 billion Puerto Rico Aqueduct and Sewer Authority (PRASA) revenue bonds, series A, B,2012A and 2012B (senior lien) to 'B+' from 'BB+';--$658 million PRASA Commonwealth guaranty revenue bonds to'BB-' from 'BB';--$1.4 billion Puerto Rico Public Building Authority government facilities revenue bonds guaranteedby the Commonwealth to 'BB-' from 'BB'.The 'B+' rating on PRASA's senior lien revenue bonds is on Negative Watch in light of near-termliquidity requirements dependent on third-party extension of credit or market access.All other ratings carry a Negative Rating Outlook. The Rating Outlook indicates the direction a ratingis likely to move over a one to two-year period. A Rating Watch indicates that there is a heightenedprobability of a rating change and the likely direction of such change.The rating actions follow passage of the Puerto Rico Public Corporation Debt Enforcement andRecovery Act, which establishes a restructuring regime for public corporations that may becomeinsolvent. The Act contemplates two procedures for addressing debt obligations. While they areintended to restore solvency over the long-term, both procedures entail debt restructuring that wouldtrigger suspension of debt payments and preclude the timely payment of principal and interest duringthe pendency of the proceedings.Fitch downgraded the rating on $8.7 billion of Puerto Rico Electric Power Authority (PREPA) powerrevenue bonds to 'CC' on June 26 based on the agency's belief that a debt restructuring or defaultby the Authority is probable in light of the Act, and given the near-term liquidity demands broughton by maturing bank lines of credit and the required repayment of outstanding loans due in July andAugust 2014.Fitch does not rate any other Commonwealth appropriation- or special tax-secured debt.SECURITYCOMMONWEALTH GO & GUARANTEED: GO bonds are secured by the good faith, credit andtaxing power of the Commonwealth of Puerto Rico. Strong legal provisions for GO debt includea constitutional first claim on Commonwealth revenues, including transportation-related and rumexcise tax revenues that are dedicated to specific authorities and other bonds. Bonds of the PuertoRico Public Building Authority and PRASA that are guaranteed by the Commonwealth are backedby the Commonwealth's commitment to draw from any funds available in the treasury. The goodfaith and credit of the Commonwealth is pledged to any such deficiency payments, resulting in arating that is the same as the Commonwealth's GO bonds.COFINA: COFINA bonds have a security interest in and are payable from the Commonwealth'ssales and use tax. COFINA is an independent governmental instrumentality of the Commonwealthand affiliate of the Government Development Bank for Puerto Rico (GDB) established by specificlegislation.PRASA: PRASA bonds are secured by a gross lien of all authority revenues related to PRASA'scombined water and sewer system, as defined in the amended master agreement of trust (MAT),senior to all other debt or expenses of PRASA. Under the provisions of the restructuring act, the grosslien will not be enforceable and is converted effectively to a net lien similar to that under Chapter 9of the Federal Bankruptcy Code that applies to special revenue bonds.EMPLOYEES RETIREMENT SYSTEM: The ERS bonds are a limited, non-recourse obligationof the pension system, payable from and secured by a pledge of statutorily required employercontributions to the system.KEY RATING DRIVERSCOMMONWEALTH GO & GUARANTEED: The Commonwealth has repeatedly demonstrated itsfocus on bolstering the fundamentals of its general credit, including through continued progressin closing the general fund budget deficit and limiting exposure to public corporation shortfalls.However, the one-notch rating downgrade reflects marginal deterioration in credit fundamentalsdespite these efforts, with continued economic weakness, revenue underperformance, and challengesto fiscal stabilization efforts, including reform of the teachers' pension system. Although passage ofthe Public Corporation Debt Enforcement and Recovery Act does not have a direct negative effecton the GO credit, Fitch will closely monitor how passage of the Act affects future market access andcommitment to bondholders. Fitch continues to believe that the ultimate success of efforts to put theCommonwealth's finances on a sustainable path will be driven by the performance of the economy.Maintenance of the Negative Outlook reflects both the continued weakness of economic performanceand the significant implementation risks to achieving budget balance.COFINA: Fitch is lowering its rating on the COFINA bonds to the level of the Commonwealth'sgeneral credit. Pursuant to Fitch criteria, the amount of credit given to a special tax security istempered by the risk that the state, faced with extreme financial stress, could exercise its sovereignpowers to the detriment of bondholders. Although COFINA bonds are specifically excluded in thePublic Corporation Debt Enforcement and Recovery Act, the passage of the Act has substantiallyincreased Fitch's assessment of the risk that the Commonwealth may take steps to the detrimentof COFINA bondholders if the Commonwealth considered that a fiscal emergency and its needto provide essential services required legislative action limiting revenues available to COFINA.Such an action would clearly be subject to challenge by bondholders on grounds of unconstitutionalimpairment of contract similar to the action currently being pursued by bondholders challengingthe Act. While bondholders could ultimately prevail on such claims, a default in payment wouldprecede any such outcome. Fitch's ratings reflect the probability of default and do not consider thepossible ultimate recovery on a successful impairments claim. As such, in Fitch's opinion, followingthe change in law a rating distinction between the GO and COFINA credits is no longer warranted.Fitch does not place COFINA debt below the Commonwealth's GO as the agency believes that ifcircumstances warranted a shift in COFINA revenues to fund the general government, the GO bondswould be equally likely to default. Similarly, there is no longer a rating distinction between the seniorand subordinate COFINA liens, as the legal security of each would warrant a higher rating in theabsence of Commonwealth risk factors.PRASA: The downgrade to 'B+' from 'BB+' reflects the downgrade of the Commonwealth's GOrating as well as the implementation of the Act and resulting weakened legal protections of publiccorporation bondholders (including PRASA bondholders). Further, the downgrade on PRASA'srating reflects the central government's ability to directly or indirectly exert influence that could haveadverse implications to PRASA's operations, pointing to a rating that Fitch currently believes canbe no higher than that of the Commonwealth GO. Fitch notes that a one-notch distinction belowthe Commonwealth GO as well as Negative Watch is warranted despite PRASA's currently soundoperating position, due to the market challenges PRASA may face over the coming months as it seeksto refinance certain bank lines of credit (LOC) and procure funds for its largely regulatory-drivencapital improvement program (CIP).EMPLOYEES RETIREMENT SYSTEM: The ERS bonds continue to be rated on par withthe Commonwealth's GO rating, reflecting the strong legal obligation for employers to makecontributions to the system, the long history of timely payment of pension contributions to the system,satisfactory coverage of debt service requirements by pledged revenues, and the general credit qualityof the Commonwealth of Puerto Rico, the largest contributor. Puerto Rico Supreme Court decisionsprovide protection against the Commonwealth legislature lowering the statutory contribution rate,and required employer contributions to the system have increased in recent years. Given that GObondholders have a claim on Commonwealth revenues senior to contributions due to the pensionsystems, the rating on the ERS bonds can be no higher than the Commonwealth GO rating. LikeCOFINA, the ERS was specifically excluded in the Debt Enforcement and Recovery Act.RATING SENSITIVITIESCOMMONWEALTH GO & GUARANTEED: Maintenance of the current rating will requirestabilization in economic performance and emergence from the long recessionary period. In addition,failure to show continued progress toward structural balance would pressure the rating. Finally,consistent external market access, including for intra-year general fund cashflow borrowing, isimportant to the stability of the rating.COFINA: Going forward, the rating on the COFINA bonds will be sensitive to changes in theCommonwealth's GO rating, to which it is now linked. The rating continues to be sensitive to theperformance of the pledged sales tax, although for the foreseeable future the GO rating is expectedto be the limiting factor.PRASA: Difficulty or perceived inability to refinance PRASA's outstanding bank LOCs and accessfunds for its CIP in the coming months would put negative pressure on PRASA's rating. Also, therating on PRASA's revenue bonds likely will be influenced by movement of the CommonwealthGO rating for the foreseeable future. Finally, deterioration in financial results that threaten PRASA'sability to achieve at least break-even results would likely result in downward pressure on the rating.EMPLOYEES RETIREMENT SYSTEM: The rating on the ERS bonds is sensitive to changes in theCommonwealth's GO rating, to which it is linked due to the dominant Commonwealth role in makingthe employer contributions that secure the bonds. The rating is also sensitive to the maintenance ofadequate debt service coverage from such contributions.CREDIT PROFILECOMMONWEALTH GO & GUARANTEEDThe 'BB-' rating on Puerto Rico's GO and GO-guaranteed debt reflects demonstrated weakness in thePuerto Rican economy, very high liabilities including outstanding debt and unfunded pensions, stillchallenged financial operations, and limited financial flexibility.The Commonwealth's economy has been in recession since 2006. Although some recent informationsuggests nascent stabilization, albeit at weak levels, results are mixed. Nonfarm employment hasbeen essentially flat in 2014 after declines in 2013. The unemployment rate of 13.8% for May 2014compares favorably to a peak of 16.9% in May 2010, but incorporates continued drops in the laborforce that have once again accelerated year-over-year in recent months. The rate of decline in GDB'smonthly economic activity index has slowed notably this year; however, monthly year-over-yeardeclines persist (down 1.1% in May). Fitch sees the economy as a primary driver of future ratingdirection for the GO credit.Following a long history of large budget deficits and a reliance on borrowing to fund operations,the general fund gap has been reduced considerably. Most recently, the enacted fiscal 2015 budgetreportedly continues strong efforts to bring general fund spending in line with revenues. Fitch believesachieving and maintaining balance will remain challenging, but the commitment of management tothis goal appears strong. On the downside, the Commonwealth has had to grapple with significantunderperformance in corporate tax revenues in fiscal 2014. The Commonwealth's above-averagereliance on corporate taxes remains a concern, given the potential volatility and concentrationinherent in these revenue streams, and management is reportedly considering a substantial revisionto the revenue system.Puerto Rico's bonded debt levels and unfunded pension liabilities are very high relative to U.S. states,with a large amount of outstanding debt issued for deficit financing purposes. Pension funding willremain exceptionally low even with the significant pension reform effort undertaken by the currentadministration, and the April 2014 Puerto Rico Supreme Court decision finding recent reforms of theteachers' retirement system unconstitutional presented the administration with yet another challenge.The Commonwealth has stated in the past that without reform the teachers retirement system wouldconfront an annual cash flow deficit beginning in fiscal 2020.Puerto Rico's capital markets access deteriorated steeply in 2013 and the Commonwealth has becomeincreasingly reliant on markets other than traditional municipal investors for external financing. Thesuccessful sale of $3.5 billion in GO bonds in March 2014 provided some critical breathing room,but needs remain, including for general fund cashflow borrowing. Reliable external market access isimportant to long-term stability, and how passage of the Act affects market access will be a significantrating factor for Fitch.COFINABonds issued by COFINA are secured by the Commonwealth's island-wide sales and use tax, whichbecame effective on Nov. 15, 2006. The tax was instituted as part of Puerto Rico's 2006 tax and fiscalreform, with COFINA created to refinance appropriation debt of the Commonwealth and thereby freeup general fund resources. The Commonwealth expanded leveraging of the revenue stream in 2009as part of a fiscal and economic package designed to stimulate Puerto Rico's economy and addressrecurring budget deficits.Annual debt service coverage by pledged revenues is considerable; based on fiscal 2013 revenues,debt service for the year was covered 5.2x for the senior lien and 1.9x for the first subordinatelien. However, the final maturity of the bonds is very long and the program's rising debt serviceprofile requires some growth in revenues to achieve coverage of later maturities, particularly for thefirst subordinate lien bonds. Fiscal 2013 revenues would be sufficient to fund debt service withoutgrowth through 2056 (senior lien) and 2030 (first subordinate lien). These figures do not include theadditional 0.5% recently added to the pledged sales tax to boost coverage or the above-trend growthin fiscal 2014 due to base expansion.Sales tax collections have proven resilient, increasing since the lowest point in the recession evenas the economy has remained weak. Collections fell in only one year during the recession, by 4.5%in fiscal 2009. Total sales tax revenue is up 6.5% year-over-year through May 2014. This is beloworiginal expectations for the year, reflecting underperformance of the sales tax changes included inthe budget to increase revenues, but still solid growth given continued economic sluggishness.Strong legal opinions that have been provided with COFINA offerings state that neither theCommonwealth general fund nor Commonwealth GO bondholders have a claim on pledged salestax revenues until COFINA debt service is fully funded each year. Strong non-impairment languageprovides some additional assurances to bondholders. Nevertheless, as noted above, in light of theCommonwealth's willingness to change law to the detriment of bondholders with passage of thePublic Corporation Debt Enforcement and Recovery Act, Fitch no longer believes that the structureprovides sufficient confidence in superior prospects for full and timely payment to warrant a ratingabove the Commonwealth's GO rating.PRASAPRASA faces potential near-term challenges to takeout expiring LOC from Puerto Rican banks andraise significant funds for annual capital expenditures in light of market concerns relating to the Actand PREPA's deteriorating credit . PRASA currently has drawn $200 million on its bank LOCs andis expected to make draws up to the maximum $350 million prior to expiration of the LOCs in March2015. The LOCs are solely for interim capital financing and PRASA expects to seek capital marketaccess prior to expiration of the LOCs to fix out the LOCs with long-term debt. Simultaneously,PRASA also hopes to raise sufficient monies to fund its remaining fiscal 2015 - 2016 capital needsand possibly fiscal 2017 capital demands as well. Effecting the long-term takeout of the LOCsand generating capital funding resources for some period of time will be critical to removal of theNegative Watch.PRASA currently is operationally sound after relying on the commonwealth and GDB to addressshortfalls in cash flows for the last several years. PRASA's turnaround was the result of an average67% rate hike enacted for fiscal 2014. For unaudited fiscal 2014, PRASA generated $1.05 billion inrevenues (1% under budget) while spending $691 million towards operations (1% under budget) andincurring debt service costs $28 million under budget. Based on these results and excluding the $86million in expected rate stabilization fund (RSF) transfers, total debt service coverage (DSC) for theyear on a net revenue basis was 1.31x compared to a budgeted 1.19x; if expected RSF transfers arededucted from revenues available for debt service then total DSC was 1.0x for the year.PRASA has updated its projections through fiscal 2018 and these continue to point to self-sufficientoperations, generally favorable operating performance and no additional rate hikes. PRASA'sassumptions currently appear reasonable but operating results could be negatively influenced fromchanges in PRASA's operating environment.For forecasting purposes, PRASA has assumed that the current preferential electricity rate remains inplace but that a planned reduction in the rate in fiscal 2017 does not occur. Based on this change inassumption alone, PRASA plans to divert all surplus revenues for fiscals 2014 - 2015 to its RSF anduse these funds to offset the higher than expected energy costs beginning in fiscal 2017 in order tomaintain 1.0x DSC and forestall additional rate hikes. In PRASA's prior forecast a portion of surplusrevenues were to be utilized for pay-go capital purposes, so this change will result in higher borrowinglevels than previously anticipated, albeit only modestly. If PREPA rescinds the preferential ratesaltogether, the forecast could come under further pressure. Officials have indicated that PRASAwould pass-through such costs immediately, but this would place added pressure on PRASA's alreadyburdened rate base.PRASA's projections prudently do not include $37 million in expenditure cuts mandated by Law66, which should add some cushion to financial results in the coming years. PRASA has includedthe corresponding reduced revenues from the commonwealth related to the law's requirementthat PRASA provide fiscal emergency contributions to the commonwealth by not charging forservices. Fitch notes that even with the expenditure reduction offset, the commonwealth's actionsto unilaterally demand assistance from PRASA exposes PRASA to future potential fiscal andoperational challenges and limits PRASA's credit fundamentals from previous expectations.EMPLOYEES RETIREMENT SYSTEMThe ERS pension funding bonds are payable from and secured by a pledge of statutorily requiredemployer contributions to the system. Employer contributions are made by the Commonwealth,associated public corporations, and municipalities. There are 215 contributing employers to thesystem, but the central government represents about half of total contributions to the system and thereare strong interrelationships between other contributors and the central government. No retirementsystem assets or Commonwealth backstop is available to the bonds and bondholders have no claimon employee contributions.There is a strong legal obligation for employers to make contributions to the retirement system , a longhistory of timely payment, and legal protections against the legislature making changes to the systemthat would reduce the system's funded status. Although subject to appropriation, the contributionsare appropriated annually along with appropriations for employee compensation and have a legalpayment priority after only public debt. Contributions are made along with payroll as part of anemployer's payroll cycle (15 days or monthly), with about 50% of total contributions made throughthe Commonwealth's Department of Treasury payroll system.The obligation to pay is a percentage of payroll calculation rather than a fixed dollar amount and, assuch, revenues are driven by trends in payroll and the required contribution rate. Required employercontributions to the system have increased in recent years, and the Commonwealth is implementingcontribution rate increases to address funding deficiencies in the system. By the end of the 10-year ramp-up period, pension contributions will have increased from 9.275% of covered payroll, thestatutorily required employer contribution rate in place from 1990 to 2011, to 20.525%, all of whichis pledged to bondholders.The debt structure is somewhat weak with a very long final maturity (50 years) and rising debtservice profile. However, pledged revenues provide satisfactory annual coverage of debt servicerequirements and the required contribution increases will support coverage going forward. In fiscal2013, the statutory employer contribution of $425 million provided 2.5x coverage of annual debtservice and 0.99x coverage of MADS ($429 million in FY 2028).The rating on the ERS bonds is the same as that assigned to the Commonwealth's GO bonds,as the Commonwealth is the largest employer contributor and contributions have a strong legalpriority. However, given that GO bondholders have a claim on Commonwealth revenues senior tocontributions due to the pension systems, the rating on the ERS bonds can be no higher than theCommonwealth GO rating.
