Puerto Rico Government Development Bank Chairman David Chafey and Gov. Alejandro Garcia Padilla unveil the restructuring bill.

The municipal bond market prepared for the possibility of its biggest default ever after the Puerto Rico legislature approved a law to allow public corporations to restructure their debt.

Passage of the law spurred Fitch Ratings to lower $8.7 billion of Puerto Rico Electric Power Authority debt to CC from BB on Thursday, calling a default "probable." Moody's Investors Service cut its rating on $8.8 billion of PREPA debt to Ba3 from Ba2, citing "concerns about increasingly tight liquidity," and saying the law "suggests the possibility of a restructuring of some kind."

On Friday Standard & Poor’s downgraded PREPA to BB from BBB-minus. Moody’s downgraded the senior revenue bonds of the Puerto Rico Aqueduct and Sewer Authority to Ba3 from Ba2 and the senior revenue bonds from Puerto Rico Highway and Transportation Authority to Ba3 from Ba1. Both agencies cited the restructuring bill.

A default on that much debt could dwarf the record $2.4 billion default that preceded Detroit's bankruptcy last year. Puerto Rico's restructuring law comes three months after the commonwealth issued $3.5 billion of general obligation debt in a record setting municipal junk bond sale

Governor Alejandro Garcia Padilla's office sought to downplay the prospects of debt restructuring under the bill other than in extreme cases.

"We are very protective of our obligations and the faith and credit of the commonwealth," a source in the governor's office said. The public corporations would use the restructuring bill as a last resort; perhaps only one or two public corporations will end up using it, she said.

The government is not working on any similar restructuring bill for commonwealth debt proper, the source said. She pointed out that the commonwealth's general obligation debt is guaranteed by its constitution.

The Puerto Rico House of Representatives and Senate approved the restructuring bill on Wednesday, and Puerto Rico Gov. Alejandro García Padilla was poised to sign it on Friday, the source in the governor's office said.

The restructuring act, called the Puerto Rico Corporations Debt Enforcement and Recovery Act, offers two restructuring paths. In Chapter 2 a public corporation would try to reach an agreement with its creditors. If the corporation got 75% of the creditors to approve a plan, the corporation would turn to a court to approve a plan. The plan would bind all the corporation's creditors.

In Chapter 3, a committee would be appointed to negotiate for the creditors. A court would approve the ultimate deal.

Normally, public corporations are expected to try Chapter 2 before they turn to Chapter 3.

If public corporations find themselves in financial distress and wish to use the restructuring measures, they will turn to the GDB leadership for approval to use the measures, according to the source close to the governor. Alternately, the measures allow the governor to initiate the restructuring measures for a corporation.

According to Robert Donahue, managing director at Municipal Market Advisors, "the bill sets a minimum recovery for each creditor at the sum of 1) the minimum recovery each creditor would receive were all creditors to exercise their remedies simultaneously, and 2) a pro-rata share of a hope note, secured by 50% of excess cash flow generated by the corporation for ten years followng the restructuring."

The Puerto Rico government has no particular public corporation in mind for restructuring, a spokesman for the Government Development Bank of Puerto Rico said.

In response to inquiries from the Bond Buyer to three Puerto Rico public corporations, one -- PREPA -- indicated it was leaving the door open, another denied an interest in restructuring, and a third did not respond.

"As previously reported, PREPA is working with its advisors to evaluate various strategies that would allow it to improve its operational and financial performance while maintaining continuity in the service we provide to our customers," Puerto Rico Electric Power Authority administrative assistant Yenis Abraham Gonzalez said. "We do not expect to comment on any specific initiatives until we have a clear path forward."

Puerto Rico Aqueduct and Sewer Authority said it doesn't anticipate restructuring, after yields on its debt surged as high as 43% on Wednesday. PRASA "does not consider necessary the use of the restructuring law," chief executive officer Alberto Lazaro said in an email. "Our financial results and projections are healthy and sufficient to pay all projected expenses and debt service. Our debt service reserves are properly funded as required by the master agreement of trust (MAT). PRASA reviewed its rates on July 2013; such rates are sufficient and will generate enough revenues to cover all our obligations and some reserves. Also, if necessary, PRASA has the ability to adjust its rates (4.5% per year) beginning in fiscal 2018."

A spokesperson at the Puerto Rico Highways and Transportation Authority did not immediately respond to an inquiry.

The law explicitly excludes commonwealth government entities and some public corporations from using the restructuring measures. Among those excluded are the commonwealth government; the 78 municipal governments; the GDB and its subsidiaries, affiliates and ascribed entities; the Puerto Rico Sales Tax Financing Corporation (COFINA); the University of Puerto Rico, the Puerto Rico Infrastructure Finance Authority; the Puerto Rico Industrial Development Company; and the Municipal Finance Agency.

Municipal bond analysts generally said the bill was a credit positive for Puerto Rico's commonwealth debt and a credit negative for its public corporation debt.

"This is overall a good thing for Puerto Rico COFINA and general obligation bondholders and a worrisome development for public corporation paper," analysts at REOF Capital said in an email. REOF doesn't see the law as "a huge disaster for the public corporation bonds, as those debts were trading already at huge discount, which implies some expectancy of restructuring was already built into the trading."

The government also said the program aimed to strengthen the government's credit. "Over the past year, the GDB has reiterated that the public debt of the commonwealth should not be seen as a sum of debts to a single debtor, but rather as individual loans supported by various sources of revenues and income, with certain priorities established by law or contract," GDB chairman David Chafey said. "The GDB's message to the market has been consistent in the sense that neither the commonwealth nor the GDB is in the position to subsidize or bail out public corporations and that they need to become self-sufficient."

The restructuring bill "also protects Puerto Rico's GO debt by giving public corporations the opportunity to address their financial challenges once and for all and thereby no longer depend on the general fund," Chafey and Puerto Rico Secretary of the Treasury Melba Acosta Febo said in a statement.

The GO and COFINA bonds are the "true sovereign debt in the eyes of the government," the REOF Capital team said. "In a way they are right, in other municipalities there's no assumption that the debt of the public authority is the debt of the state and that it will be covered by funds other than the pledged funds."

Janney Capital Markets managing director Alan Schankel was more cautious about the proposal. "A case can be made that isolating the problems of an issuer such as PREPA from the Treasury, strengthens the central government, but the proposal to facilitate debt restructuring raises concerns about what a next step might be should, for example, Treasury revenues fall short of projections and the government is unable to gain market access to finance any resulting debt," he wrote in the Janney Daily Fix. "Will the law act as a firewall to protect the government from the fiscal stresses of public corporations or is it the first step towards the slippery slope leading to general obligation restructuring?"

Donahue added: "This bill may represent Puerto Rico's pivot with respect to bondholders: meaning, a transition from describing debt obligations as inviolable to describing the risk if debt payments and bondholder remedies interfere with the corporations' other stakeholders and their critical public missions ... We expect there will be some pressure, if restructurings wind up not creating sufficient cash flow, to expand the view of public missions needing protections from bondholders: a cautionary message to GO and COFINA lenders."

Whatever the bill means for the commonwealth debt, it is worrisome for the public corporation debt, analysts said. "You don't hire a surgeon if you don't need surgery, so it appears more likely than not that a company or more than one will use the legislation," said Joan Vidra, managing director for Opportunities Emerging & Frontier Markets Advisory LLC.

As for what public corporations might use it, Vidra, Axios Advisors managing partner Triet Nguyen, and the REOF Capital group mentioned PREPA as being likely. "The way PREPA was going, something had to be done," Nguyen said. "There wasn't even weeks to go."

Some bond analysts have said recently that the electric authority has substantial hurdles in the near term. It has outstanding loans of $671 million due in July and August based on a $250 million line of credit and a $550 million line of credit. PREPA is seeking an extension of the lines, Fitch Ratings managing director Dennis Pidherny said. On Thursday Pidherny said he thought it is unlikely that the GDB will provide "bridging liquidity support" that would aid PREPA in avoiding a default.

PREPA's electrical rates are already high. It would be politically difficult to raise them further to support its debt, Nguyen said. Lilliam Maldonado, spokeswoman for Puerto Rico House Representative Jesús Santa Rodríquez, said that PREPA was considering rate increases.

A rate increase would be counter to the government's efforts to lower the rates to aid the economy, Nguyen said.

After PREPA, the Puerto Rico Highways and Transportation Authority might be another candidate for the debt restructuring, the REOF team said. Their revenues are probably not good enough for its debt service.

"The main purpose of the law is to protect the interests of the people of Puerto Rico and to ensure that the gap in federal law [which does not provide for public corporation restructuring] does not jeopardize essential public services," Melba Acosta and Chafey said in a written statement. "The law protects the interests of bondholders and creditors, along with other stakeholders, by giving corporations a way to negotiate with their primary stakeholders to ensure a fair and equitable allocation of resources and create a more promising future for their finances and for all the people who depend on them."

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