Puerto Rico general obligation debt (CC/Negative) continues to remain highly vulnerable to default, in Standard & Poor's Ratings Services' view, despite payment in full by the Government Development Bank for Puerto Rico (GDB) of $354 million in scheduled debt service on Dec. 1, including $267 million of GDB note principal guaranteed by Puerto Rico, and the governor's release of an executive order that diverts revenue, which would otherwise support about $7 billion of non-GO debt issued by certain public corporations, to the payment of GO debt service.
Even if Puerto Rico prioritizes its $331 million GO interest payment due on Jan. 1, 2016, at the expense of other bondholders, this diversion of revenue pledged to other bonds would merely postpone an eventual GO debt default because GO debt service payments due July 1, 2016, and afterwards remain at risk due to the likely continued deterioration in the Commonwealth's cash position over time, S&P said.
The executive order diverting revenue does not reference the Puerto Rico Sales Tax Financing Corporation (COFINA) (CC/Negative). COFINA will likely pay its Feb. 1 and May 1, 2016, interest payments and Aug. 1, 2016, principal and interest payments as these payments will be made from sales taxes already segregated and delivered to the bond trustee in the first half of the fiscal year that began in July, S&P said.
COFINA offering documents state that pledged COFINA revenues are not subject to diversion in favor of GO debt service. However, the rating agency believes COFINA debt service payments beyond August could remain at risk due to potential worsening of the commonwealth's cash flow over the next several years as pension and health care costs grow substantially, even if public corporation debt service is diverted to improve the Commonwealth's cash position.
The governor's executive order, signed on Dec. 1, diverts revenue pledged to the payment of debt issued by the Highways and Transportation Authority ($4.6 billion of gas tax and toll road secured bonds), Infrastructure Financing Authority ($1.9 billion of rum tax secured bonds), and the Convention Center District Authority ($398 million of hotel tax secured bonds), as well as certain revenues of the Metropolitan Bus Authority and the Integrated Transport Authority, to the payment of GO debt service.
Bond debt service reserves for Highway and Transportation Authority and Convention Center District Authority debt will enable payment of debt service on Jan. 1, 2016, and potentially July 1, 2016, the rating agency said. However, the Infrastructure Financing Authority debt indenture does require a bond debt service reserve, and it is unclear to us what funds may be available to pay this debt on Jan. 1, 2016. Continued diversion of revenue will lead ultimately to depletion of reserves and eventual default on bonds secured by the diverted revenue, S&P said.
A planned default on non-GO tax-secured debt issued by Puerto Rico's public corporations could open the Commonwealth to extensive and potentially disruptive litigation, S&P said. For example, it calculates that the Highways and Transportation Authority junior lien revenue debt had 1.45x coverage of maximum annual debt service by fiscal 2013 pledged revenues (the last audited year), indicating that bondholders may have a strong legal position to dispute diversion of pledged bond revenue to pay GO debt service, which in effect puts payment of other operating expenses the Commonwealth is still proposing to pay, such as Christmas bonuses to government employees, ahead of payment of payments owed to bondholders. Puerto Rico's inability to file for Chapter 9 bankruptcy under federal law strengthens bondholders' ability to pursue their claims. In its view, resulting litigation from default on any type of tax-supported debt could be costly, disorderly, and disruptive.
The release of only summary month end cash flow projections by the Commonwealth, without a detailed breakout of how it was calculated, makes predicting the exact timing of a potential default inherently uncertain, S&P said.
However, it believes the magnitude of cash flow loans sold by the Commonwealth when it was last able to access the external note market in 2015, budget shortfalls since then, and its most recently disclosed historical cash position all indicate significant cash flow stress.
Puerto Rico's most recent (Nov. 6, 2015) quarterly report projects a negative $72 million cash position at the end of November 2015, followed by a negative $277 million at the end of December 2015, although the governor's recent executive order diverting non-GO tax-secured debt revenue to pay GO debt service could temporarily improve cash flow.
If it makes its Jan. 1, 2016, GO debt service payments, Puerto Rico's cash position could improve temporarily in mid-January. At that time, sales taxes pledged to COFINA on a first dollar basis at the beginning of each fiscal year would have fully filled the COFINA annual debt service accounts held by the COFINA trustee. At that point, excess COFINA revenues become available as monthly general fund revenue. April individual income tax returns could also temporarily improve second half general fund revenue.
Puerto Rico's Nov. 6, 2016, quarterly report projects positive ending cash positions from February 2016 through May 2016, but then worsening again to a negative $775 million at the end of June 2016 as GO principal and interest payments become due on July 1, 2016. The diversion of non-GO tax-secured debt service revenue for payment of GO debt service would be insufficient on its own to fully make up for the projected end of June cash shortfall, S&P said. The Commonwealth's cash position thereafter is likely to remain poor, as COFINA sales tax/VAT annual segregation of pledged revenue debt service resumes in the first half of fiscal 2017.
It is likely Puerto Rico will have unbudgeted continuing operating deficits in fiscal 2016 and 2017 that could worsen cash flow from its current forecast, S&P said. Puerto Rico currently projects a $355 million fiscal 2016 revenue shortfall compared to budget, which it expects to fully close with mid-year budget adjustments. However, the rating agency believes there is a strong probability of unbudgeted 2016 budget shortfalls based on past history of revenue shortfalls and unbudgeted growth in expenditures.
Despite a balanced budget, the Commonwealth ran a $703 million operating deficit in fiscal 2015, adding to cash flow pressure since it last sold $1.5 billion of cash flow notes at the beginning of fiscal 2015.
Beyond fiscal 2016, large projected increases in pension payments and health care system costs will only increase cash flow pressure, absent drastic action that the island in its view appears unwilling to take.
Puerto Rico appears to be in a situation with no good choices, even if it prioritizes the payment of GO debt over non-GO debt. If it chooses to pay GO debt, which has a constitutional priority, but not pay other tax-secured debt, such as the Transportation and Highways Authority debt, the litigation that would likely result could cause a major disruption.
At the same time, the governor's proposal for what would have been in effect a financial control board appointed by him has been watered down in the legislature into what S&P would categorize as an advisory committee, while debt restructuring negotiations appear to be bogged down by the wide variety of debt security structures and parties with competing interests.
Sooner or later, the rating agency said, escalating debt service, pension, and health care costs will fully deplete the Commonwealth's liquidity and prevent it from making even GO debt payments--if not on Jan. 1, 2016, then when larger GO principal and interest payments come due on July 1, 2016 or beyond.
Contributing to financial uncertainty is the lack of fiscal 2014 Commonwealth audited financial statements a year and a half after the close of the fiscal year, prepared on a modified accrual GAAP basis. Puerto Rico's quarterly disclosure report indicates fiscal 2014 financial results on a GAAP basis could look much worse than the $1.2 billion budgetary basis general fund operating deficit.
A solution to Puerto Rico's financial crisis will require an accurate assessment of its current position consensually agreed upon by both creditors and the federal government, S&P said. To complicate matters, receipt of more timely GAAP statements may be unlikely in the near term: three of the Commonwealth's agencies responsible for over 50% of general fund expenses currently have separate accounting systems that are unable to interact on a timely basis with the Commonwealth's central accounting system.
It has determined, based solely on the developments described herein, that no rating actions are currently warranted.
