Puerto Rico’s Downgrade Shows Debt Law Can’t Contain Rot

A law allowing some Puerto Rico government entities to restructure debt outside bankruptcy failed to contain a crisis as its credit rating was cut three levels, imperiling the U.S. commonwealth’s ability to finance itself.

The island’s electric authority, which could shed some of its $8.6 billion in debt by making creditors accept losses, said yesterday after the market’s close it had paid off maturing bonds in full. That was only after Moody’s Investors Service sent Puerto Rico’s rating on $14.4 billion of general-obligation debt to B2 from Ba2, and reduced sales-tax debt to speculative grade. The cuts and the restructuring measure restrict Puerto Rico’s ability to borrow, said Peter Hayes, head of municipal debt at BlackRock Inc.

“With these ratings and this legislation, that access to the market is gone,” said Hayes, whose New-York based firm oversees $108 billion of munis.

Little is certain about what has grown to become a $73 billion obligation for the commonwealth and its agencies. Most of the debt is tax free, held in 66 percent of U.S. muni mutual funds as the yield created by risk made it a mainstay of U.S. municipal finance. The downgrade now leaves those investments in danger and the poverty-ravaged island with few options to borrow money.

Shaky Promise

Puerto Rico’s economy has contracted about 11 percent since 2006, according to its Planning Board. The unemployment rate of 13.8 percent is more than double the U.S. average, and about 45 percent of residents are in poverty, according to U.S. Census data. The commonwealth for years has borrowed to keep its government functioning, and investors hungry for the rewards of risky debt kept lending.

Governor Alejandro Garcia Padilla has said the commonwealth will repay its general obligations, yet the new law has sapped investors’ confidence in Puerto Rico because it “brought into question the value of their promise to pay any debt,” said Guy Davidson, who helps manage $30 billion of state and local debt as director of munis at AllianceBernstein Holding LP in New York.

One of the largest debtors that could be restructured is the Puerto Rico Electric Power Authority, which supplies almost all the island’s electricity and is in such straits that it has dipped into its capital budget to purchase fuel.

Pressure Shift

Bondholders were paid in full yesterday on maturing securities, the Government Development Bank, which works on the commonwealth’s finances, said in a statement. The law, which has been challenged in court as a circumvention of the federal bankruptcy system, means that may not always be the case.

A revision of Prepa’s debt would be the largest ever in the $3.7 trillion municipal-bond market, more than the $8 billion of general obligations and water-and-sewer debt in Detroit’s record bankruptcy and the $4.2 billion that led to the failure of Jefferson County, Alabama.

Puerto Rico has “a new preference for shifting fiscal pressures to creditors, which, in our view, has implications for all of Puerto Rico’s debt, including that of the central government,” Moody’s analysts led by Ted Hampton wrote in today’s report.

The ratings firm dropped senior-lien sales-tax bonds, known as Cofina debt, to Ba3, three levels below investment grade, from Baa1. It cut the subordinate sales-tax debt to B1, four steps below investment grade, from Baa2. The change affects $15.6 billion of sales-tax debt and strips Puerto Rico of a borrowing tool rated investment grade by Moody’s.

‘Good Name’

Garcia Padilla, who took office in January 2013, said Moody’s downgrades were unfair to Puerto Rico’s residents and ignored the island’s improving economy and reduction of multi-year deficits.

“For these reasons and others, I have instructed the Attorney General to assert the truth and clear the good name of Puerto Rico,” Garcia Padilla said in a statement. “That credit agency, and any other entity acting alike, will have to answer for this offense.”

His demand for redress still may not stimulate demand in the market. Commonwealth securities lost 2.13 percent yesterday, the biggest one-day drop since Oct. 10, according to S&P Dow Jones Indices. The entire muni market lost only 0.14 percent.

Puerto Rico general obligations maturing July 2035 and originally sold at 93 cents on the dollar in March traded yesterday at an average 86.6 cents, down from 89.1 cents the day before, data compiled by Bloomberg show.

Puerto Rico has “reduced potential buyers by some amount, particularly the ones who are being hurt by these potential changes,” said Daniel Solender, who helps manage $15.5 billion of munis at Jersey City, New Jersey-based Lord Abbett & Co.

Before it's here, it's on the Bloomberg Terminal.