Yield spreads on Puerto Rico's debt have widened as the triple tax-exempt commonwealth's fiscal picture has worsened, according to data in a new report this week. But rating agencies say actions by a new governor and a history of coping with such stress warrant the stable investment-grade ratings.

In a Bank of America/Merrill Lynch & Co. research report entitled "Municipals: Bids Weaken," the investment bank stated that the island has "profound economic and financial challenges." In addition, Merrill questioned the commonwealth's stable outlook on its general obligation debt in light of current financial challenges on the island.

Puerto Rico GO bond spreads have widened to 300 basis points over long, state-level debt in December, but over the last month appear to have retraced to less than 250 over, reflecting prospects of improvement under the new governor and aid from the fiscal stimulus package, Merrill analysts said.

"In our opinion, investors may be deriving a false sense of comfort from the stable ratings outlooks which were restored to the Puerto Rico GO credit by [Moody's Investors Service and Standard & Poor's] subsequent to their respective downgrades of the ratings to Baa3 and BBB-minus in 2006 and 2007," Merrill analysts wrote.

"The ratings agencies have steadfastly maintained that outlook in the wake of a deep and protracted recession; a mounting general fund deficit of arguably greater comparative magnitude than the imbalance vexing the state of California; and continual reliance on external borrowing to service principal and interest payments coming due."

Fitch Ratings does not rate the commonwealth.

Puerto Rico officials are working on closing a $3.2 billion deficit within the $9.48 billion fiscal 2009 budget but are also cutting the government's payroll at a time when the island's unemployment rate is 12%.

The commonwealth is considering external borrowing through the Puerto Rico Sales Tax Financing Corp. of at least $1.2 billion of sales tax debt this year. Those bonds would help the island pay roughly $700 million of unpaid bills to service vendors, support a $500 million local economic stimulus plan, and pay down roughly $800 million of debt the commonwealth owes the Government Development Bank for Puerto Rico, its financing agent.

Yet analysts at Standard & Poor's and Moody's said the current ratings, which are one notch above junk levels, reflect the island's history of recurring deficits, high debt levels, and dependence on GDB loans to help fill budget gaps.

Both rating agencies changed their outlooks to stable from negative in 2007 after the commonwealth implemented a first-ever 7% sales tax and began crafting zero-growth budgets. Those measures followed a fiscal crisis and partial government shutdown in spring 2006, when Moody's and Standard & Poor's placed the credit on watch list for possible downgrade and creditwatch, respectively.

While the island is now facing a $3.2 billion deficit and declining revenues, analysts said they are waiting to see the impact of Gov. Luis Fortuño's stimulus plan and keeping tabs on the island's ability to access the municipal bond market.

"It's really a very, very challenging time for them," said Moody's analyst Emily Raimes. "But, they are not at the crisis state that we saw them in in 2006."

Raimes said there would need to be a "very severe or significant change or deterioration" to prompt the agency to drop the island to non-investment grade. As for the stable outlook, Moody's is waiting to see how the commonwealth closes its sizeable budget gap.

"I think if they're not able to implement their plan and coupled with an inability to put a different plan in place, that might be an indication where we would look at an outlook change," said Moody's analyst Edith Behr.

Standard & Poor's is also monitoring the island's budget, GDB's ability to extend short-term loans to the commonwealth, market access, and the recession.

"The extent to which those four factors change - and it's a very fluid situation right now with the economy especially - but also with some of the measures that the government and the Legislature are implementing, our opinion stays at this point the same," said Standard & Poor's analyst Horacio Aldrete. "It's a stable outlook and what that means is we continue to monitor the credit and monitor the factors that may influence that opinion."

In addition, Aldrete pointed out that its BBB-minus rating takes into consideration Puerto Rico's fiscal problems. While the $3.2 billion deficit may be the largest state-level deficit in the nation on a percentage of annual budget basis, Puerto Rico's ratings are lower than the two lowest-rated states. California and Louisiana carry A1 and A-plus ratings from Moody's and Standard & Poor's, respectively.

"It is true that in perspective, Puerto Rico's budget [shortfall] is higher than what we see in other states on the mainland, percentage wise, but it is also true that the rating on Puerto Rico is substantially lower than the lowest-rated state, which is A-plus," Aldrete said.

Meanwhile, investors are also watching the commonwealth and with financial problems mounting, the island's triple tax exemption could be less of an enhancement for bondholders.

"Triple tax-exempt or not, do you really want to own something that might have downgrade risk?" said Bob MacIntosh, vice president and co-director of Eaton Vance's municipal bond group. "I mean, that's what it comes down to."

Tom Dalpiaz, portfolio manager at Advisors Asset Management, said the commonwealth can no longer rely just on its triple tax exemption status to attract investors.

"They perennially have had challenges," Dalpiaz said. "I just think that the demand for triple tax-exempt paper has kind of covered that up in terms of how these things used to trade, but that veil has been lifted."

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