Analysts Positive on Puerto Rico Governor's First Year

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Municipal bond analysts are generally positive about Puerto Rico Gov. Alejandro García Padilla's first year in office, though they voice concern about the economy and the commonwealth's ability to access the bond market.

"It was one of the more remarkable fiscal turnarounds in the last 20 years," said H.J. Sims senior credit analyst Richard Larkin.

"From a bond-holder perspective, he's done a great job," echoed Oppenheimer senior portfolio manager Troy Willis.

But most analysts say that the commonwealth isn't out of the woods yet. The economy is weak and unemployment high. It will be a challenge for the government to access the bond market at reasonable rates, they say.

From December 2012 to March 2013 the ratings agencies pressured Puerto Rico by dropping its general obligation rating to BBB-minus or the equivalent, one notch above a speculative grade. They also dropped ratings on a raft of Puerto Rico government and public corporation bonds, some of them to speculative grades.

While it was a "very challenging year," Puerto Rico successfully handled many fiscal problems in 2013, said Melba Acosta Febo, secretary of the commonwealth's Treasury.

Achievements
García Padilla has taken important steps to reduce the government's budget deficit, analysts acknowledged. The fiscal year 2014 deficit is expected to be cut by 62% this year compared to last fiscal year, the governor said in a speech Thursday. The new budget includes an anticipated $1.35 billion in additional revenues.

"I think most municipal credit analysts have been very positively surprised by what this governor and his team have managed to do on the fiscal side," said AllianceBernstein senior vice president Joseph Rosenblum.

Larkin said the fiscal turnaround was on the same level of size and impressiveness as those done by Gov. William Weld in Massachusetts and Mayor Edward Rendell in Philadelphia, both in the early 1990s. However, whereas they had emphasized budget cutting to restore stability, García Padilla has emphasized tax increases, Larkin said.

Through the first five months of the fiscal year the Puerto Rican General Fund's revenues were up 12.4% from the same period in fiscal year 2012 and 2.6% compared to the budget projection.

While analysts have seen Puerto Rico's budget deficit as the immediate threat to its credit, many saw its underfunded pensions as a long-term threat.

At the start of 2013, the main employee pension system had an actuarial deficit of $25 billion and was expected to run out of money in 2019. The teachers' pension system had a $10 billion actuarial deficit and the judicial pension had a $300 million to $400 million actuarial deficit.

Largely following proposals from the governor, the Puerto Rico legislature approved an overhaul of the first plan in April and of the latter two plans in December. The reforms will assure coverage of the employee plans on a cash basis for the foreseeable future.

Some of the spending increase in the current budget is being allocated to support the main employee pension fund, said Oppenheimer senior portfolio manager Troy Willis. The $200 million is significant but is much smaller than would ultimately be needed if the main employee pension fund was not overhauled. The overhaul of the teachers' pension fund went farther than has been done elsewhere in the United States, Willis said.

The governor's achievements in his first year were also extended to the semi-autonomous public corporations, analysts said. Bond holders concerns about them were raised by rating agency downgrades from December 2012 through the spring. In the case of the Puerto Rico Aqueduct and Sewer Administration, two of the three agencies dropped its revenue bonds to speculative ratings.

García Padilla made clear early on that he would end the central government's practice of providing financial support to the public corporations. In response, PRASA voted to raise its water and sewer rates by 60% in July, Willis noted.

The central government instituted a range of new taxes and revenue sharing measures to prop up the Puerto Rico Highway and Transportation Authority, Willis added.

The government also made strides in communicating with the market, analysts said.

"Although it took the better part of the year, they finally figured out in October that the market is looking for greater transparency and better disclosure," said Axios Advisors managing partner Triet Nguyen. "Since then, they've done a much better job of communicating with investors. Clarification of the COFINA lien status with regard to 'claw back' potential is one example of improved disclosure."

The government's improved the disclosure practices "still leave much to be desired: so far, it has resisted investor calls to provide full cash flow statements for the GDB, arguably the most opaque, and potentially weakest, component of their financial structure," Nguyen said.

Rosenblum agreed about the need for more information about the GDB and said the government should provide more detail on the enacted pension reforms.

Acosta Febo said that the government was late with reporting the certified accounted financial report for fiscal 2012 because it had found the previous administration had done no work on this when García Padilla came to power. Right now the government is six months farther along on preparing the fiscal 2013 CAFR than it was with the fiscal 2012 CAFR, she said. The government plans to release a commonwealth report this month updating its financial information.

Remaining Challenges
While the government has made progress, it still faces challenges, analysts said. Many singled out the persistently weak economy.

"Although some degree of stabilization can be seen over the past three months, the Puerto Rico economy continued to contract last year and demographic trends have remained extremely unfavorable," Nguyen said. Both Nguyen and Rosenblum said an improved economy is necessary for the commonwealth to be able to pay off its debt over the long-term.

The government has a strong economic development plan that has already shown progress, Acosta Febo said. The government has received thousands of job commitments from businesses, she added.

A final major obstacle is the bond market's perception of Puerto Rico risk and the commonwealth's consequent difficulty in selling bonds at reasonable rates. For this perception the past year went nothing like the way García Padilla wished, Willis said.

On Dec. 6, Standard & Poor's Indexes announced that the weighted average price of bonds in the S&P Municipal Bond Puerto Rico Index fell by 22% in 2013 up to that date. Buyers in the secondary market demanded increasing yields in the secondary market to purchase the bonds. By early November investors were asking for 325 basis points more than similarly rated debt to purchase Puerto Rico general obligation bonds.

Partly because of the island's difficulty in accessing the bond markets, in late November and early December Fitch Ratings and Moody's Investors Service put Puerto Rico bonds on reviews for downgrades.

It is unclear if the market will allow Puerto Rico to sell at an affordable rate, said Cumberland Advisors executive vice president John Mousseau.

Unlike Detroit, which was under Michigan, Puerto Rico is directly under the United States government, Mousseau noted. Washington, D.C., does not seem to have an appetite for a full bailout. However, "under the radar screen there are probably things going on we don't even know" between Puerto Rico and the Obama administration.

If the U.S. government allowed Puerto Rico to default it would send a terrible message about U.S. government debt, Mousseau said. Foreign investors would ask about the security of Federal Housing Administration and Freddie Mac or Fannie Mae debt.

Mousseau said the Obama administration may be considering either guaranteeing the principal of Puerto Rico bonds or initiating a program like the Build America Bonds program that would subsidize the bonds. The Obama administration hasn't commented on such plans.

In the last few months the Obama administration has sent members of its task force on Puerto Rico to the island to offer suggestions for economic development and getting federal aid.

Puerto Rico Government Development Bank interim president José Pagán Beauchamp said the measures the government took in the first six months allowed it to borrow in July and August. In private placements with local and international banks it placed $1.2 billion in tax and revenue anticipation notes, a $400 million general obligation bond anticipation note, a $400 million BAN for the Highways and Transportation Authority, and a $330 million BAN for the Puerto Rico Sales Tax Corp. (COFINA). The Government Development Bank of Puerto Rico purchased $300 million of the TRANS. In August the Puerto Rico Electric Power Authority sold $673 million in bonds.

With the government's recent passage of overhauls of the teachers' and judges' pension plans and the intention to do further measures in the next few weeks, the government plans to return to the market in late January or in February, Pagán said.

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