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Monday, February 10, 2014

Puerto Rico Rating Downgrades: Enron Redux?

On November 28, 2001 Enron lost its investment grade credit rating. Four days later, the company filed for bankruptcy. Those awaiting a similar collapse after Puerto Rico’s descent into junk bond territory last week will have to wait a lot longer to see the Commonwealth’s financial denouement.

The relatively slow motion nature of Puerto Rico’s fiscal collapse – if, in fact, one is occurring – underscores the differences between various classes of public sector and private sector debt. It also speaks to changes in market conditions.

As with the 2011 S&P downgrade of the US, rating agency actions had little impact on Commonwealth yields. The New York Times reported last Wednesday that the investors had shrugged off the S&P action. On Friday, the Wall Street Journal reported that Puerto Rico General Obligation debt traded at a lower yield after the Moody’s follow-on downgrade than it had earlier in the week.

The limited impact of the ratings downgrades might be attributed to market discounting – since the rating agency actions were widely anticipated. It could also speak to the greatly reduced reputation rating agencies enjoy in the aftermath of the Enron/Worldcom scandals of the early “aughts” and the subprime fiasco of 2008.

Unlike Enron, Puerto Rico can operate for some time without capital markets access. The Commonwealth can get by without financing because its fiscal deficits are relatively low and its debt is predominantly long term. It thus does not need that much new cash to finance ongoing operations or to roll over previous bond issues.

But, sooner or later, Puerto Rico will have to bring new issues to market, and many doubt whether investors will be around when it does. Commonwealth-related debt accounts for about 2% of overall US municipal bonds outstanding and its fall from investment grade leaves many traditional investors out of the running. So it would appear that there is a lot of debt and not much appetite.

In my view, this analysis misses some key institutional developments. Hedge funds and certain other classes of investors can traverse multiple markets. Further, Asian investors have accumulated billions of savings and remain on the lookout for alternatives to low yielding US Treasuries. So the constituency for Puerto Rico debt is not merely the $3.7 trillion municipal market, but a much larger audience especially if the price is right. 

Puerto Rico debt is now trading at yields much higher than that of Italy, Spain and Portugal - and is roughly on a par with Greece. In contrast to Greece, Puerto Rico is not a serial defaulter. In fact, it is part of an asset class – US state and territorial bonds – that has not seen a default in over 80 years. Further, the last default – of Arkansas in 1933 – ended in a full recovery for investors. So, from an international perspective, Puerto Rico bonds appear to offer good relative value.

Thus if new Puerto Rico bonds are offered at 8% or 9%, I expect that they will find a bid. While coupons at that level are not fiscally sustainable, the fact that most Puerto Rico government debt is long dated means that Commonwealth interest expenses as a proportion of revenue will remain low relative to previous default cases.

Unlike Enron or another private company, a US sub sovereign like Puerto Rico has secure revenue sources in the form of taxes and federal assistance. As Detroit has shown, insolvency is ultimately possible, but the path to ruin for a public sector debt issuer is usually a long one.

Notes: I purchased a small number of Puerto Rico GO bonds last month. Any opinions provided herein are my own. PF2 is an independent third party and does not provide investment advice. For my previous commentary on Puerto Rico's lack of fiscal transparency, click here.

2 comments:

Christopher T. Mahoney said...

Remember that Enron's financial disclosure was fraudulent. Is PR's also fraudulent? There hasn't been an audited financial report since June of 2012 (published in Sept of 2013). An investor would want to know what PR's prospective cash flows look like for calendar 2014. I smell a rat.

Marc Joffe said...

Thanks for your feedback, Christopher. Before joining Moody's I worked for a bank that had substantial exposure to Enron. I was impressed with the performance of the equity-based KMV credit quality measure as shown here: http://finance.eller.arizona.edu/lam/fixi/creditmod/ppt/Enron.pdf. It seems that the equity market reflected the possibility that Enron filings were fraudulent before that possibility was incorporated into its ratings. With respect to Puerto Rico's late disclosure, I agree that this is a serious concern, although many other municipal filers provide CAFRs a year or more after the end of their fiscal years.