Though analysts and municipal managers said Tuesday's Standard & Poor's downgrade of the Puerto Rico Aqueduct & Sewer Authority was widely expected, the cut — the second experienced by one of the commonwealth's issuers in as many weeks — means more stress and concern for Puerto Rico bond holders, and could likely lead to less liquidity, wider spreads, and consequently, costlier trips to market.

Municipal experts said the downgrade  of the PRASA senior-lien bonds to BB-plus from its prior investment-grade BBB-minus rating, with a negative outlook, adds another layer of concern for investors on the heels of a March 20 downgrade by Fitch Ratings and a March 13 downgrade from S&P of the general obligation rating - both one-notch to BBB-minus with negative outlooks.

The latest S&P action also lowered the rating of the authority's bonds guaranteed by the commonwealth by one notch to BBB-minus, with a negative outlook, while the stand-alone credit profile of the authority was left unchanged at BB-plus. It also creates additional strain on the commonwealth given its existing economic and fiscal imbalances - namely a $2 billion budget deficit, pension funding shortages, and lack of economic diversification - that its financing arm, the Government Development Bank, is working to repair, they said.

"Although no more so than the GO downgrade by S&P and recent Fitch downgrades, the PRASA drop is certainly indicative of the long road ahead," said Alan Schankel, managing director of Janney Montgomery Scott. "When rating agencies change a rating, they often start with the main issuer and then that change ripples through peripheral issuers," he explained.

After recently starting to show signs of tightening from previous highs, spreads on long Puerto Rico bonds in general have again started to widen out, especially in the wake of the recent downgrades, experts noted.

Spreads on Puerto Rico bonds were approximately 230 basis points wider than the 30-year benchmark triple-A GO scale as of March 22 — after peaking at 275 basis points between December 2012 and January 2013, according to Municipal Market Data. In early January 2012, by comparison, spreads were at 152 basis points.

Tuesday's PRASA downgrade, however, triggered selling in the secondary market at spreads wider than just a week ago — and even wider than the day before the downgrade. In block trading on Wednesday, for instance, a dealer sold to a customer 5s of 2033 at 5.72%, up five basis points from a comparable block trade Tuesday, according to Municipal Securities Rulemaking Board trade data. That trade took place at a yield 263 basis points higher than the 30-year triple-A GO scale, according to MMD.

Meanwhile, the volatility was more pronounced among odd-lot trades. A dealer sold to a customer 5.25s of 2042 at 5.81%, up 27 basis points from where it was sold Tuesday — which was 272 basis points higher in yield than the generic scale on Wednesday. In addition, bonds from an interdealer trade of 6s of 2038 yielded 5.96%, 23 basis points higher than where they traded Monday — and 286 basis points higher than the long GO scale on Monday.

Schankel said further PRASA downgrades could be on the horizon, since the commonwealth supports the authority directly and through the GDB. He said he has been recommending since last July that Janney's advisors limit their exposure to the troubled Puerto Rico credits and said he will continue to do so.

"If there are no significant indications of improvement in finances and economy in the near term, a drop of the GO rating to junk is likely, and the related issuer ratings would also tumble further," he said.

The GDB is offering a $750 million line of credit to the island's government for the current fiscal year to help cure a larger than expected fiscal 2013 budget gap — namely the $2.17 billion structural operating deficit.

Meanwhile, the ongoing downgrades raise concerns for investors because they are indicative of the severity of Puerto Rico's larger financial conditions, and will likely cause investors to keep their guard up and their ownership of Puerto Rico credits to a minimum, analysts said.

The PRASA downgrade on top of the commonwealth's troubles and prior GO downgrades, "continues to cause investors to be cautious going forward as more cuts may be forthcoming," said Peter Hayes, head of the municipal bond group at BlackRock Inc.

"Moody's cut [PRASA] to non-investment grade in December, so most forced selling was done then," he pointed out.

Speaking exclusively about the GO credit, Hayes said the market had factored in the downgrades, and that valuations had reflected a lower rating profile.

"The larger than expected deficit somewhat caught the market by surprise, but the [GO] rating cut itself was not a big surprise," he explained. "Now, with the rating only one notch from non-investment grade, investors will continue to keep exposures low," he said referring to the GOs. Hayes oversees the management of $109 billion in municipal assets.

Michael Pietronico, chief investment officer of Miller Tabak Asset Management, has never been a buyer of Puerto Rico GOs or PRASA, and instead prefers the stronger security pledge offered by the Puerto Rico Sales Tax Financing Corporation — known as COFINA — for instance.

"The credit quality of COFINA bonds reflects a structure and revenue pledge that insulates the bonds from the strained general fund operations of the commonwealth," Pietronico said. Miller Tabak - which has $900 million in tax-free bond assets under management - "finds security in the significant, constitutionally-backed legal protections that safeguard bond payments," he added.

The sales tax bonds, for example, have a first claim on all commonwealth sales tax revenue, providing ample current coverage, he noted.  "The sales tax base is broad and the retail environment in Puerto Rico has shown strength — even in challenging economic times."

Meanwhile, Hayes said further deterioration of the GOs to speculative nature could transform the credit into a high-yield security and eventually decrease the pool of eligible investors. That scenario could also further damage market liquidity for the bonds and continue to raise borrowing costs for the commonwealth going forward, analysts pointed out.

"There will always be buyers at any rating level — the question is at what price?" Hayes asked.

Schankel agreed that a downgrade of the GO debt to junk will curtail investor participation. "The triple-tax-exemption will continue to be a benefit, but a junk rating would limit use in many portfolios other than high-yield, which could generate selling pressure," he said.

It would also create "dramatically more severe" spread widening than for rating changes above investment-grade, Hayes predicted.

Spreads tightened earlier this year as "some investors sought higher yields and perhaps thought the worst was over for the time being," Hayes noted.

In light of the recent GO downgrades — and the GO credit hovering near non-investment grade — he said it has gotten more costly for Puerto Rico to borrow, and he believes that will again be the case this year, as it was in 2012.

"Should the [GO] rating get lowered to below investment grade, spreads would still move dramatically wider, relative to the broader market," Hayes continued.

Schankel said a speculative rating for the GO debt would compound the existing fiscal struggles and economic recovery.  "The rating agencies expect to see positive steps taken relatively quickly, and if that does not happen, junk ratings are ahead," he explained. "Strong actions taken in near term could delay — or, best case, stop — further downgrades."

Despite the obvious fiscal challenges facing Puerto Rico, Hayes is not all negative on the commonwealth's credit prospects.

"Although the fiscal and pension situation is quite dire, they are a large, strategically-important issuer with the ability to undertake many different policy initiatives to help solve its issues," Hayes said.

Schankel agreed, adding:  "The proposals we've seen so far from the new government are very positive steps, but they will face resistance from various constituencies."

"The proposed steps, such as the expanding sales and use tax base and raising other taxes would help revenues, but could also act as a brake to economic growth," Schankel added.
Moody's downgraded the commonwealth's GO debt to Baa3 back in December, while it also downgraded PRASA bonds in December to Ba1 — the highest speculative grade rating — from Baa2.

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