Archive for February, 2014

BOND RATING SCHIZOPHRENIA: What Triggered S&P’s Downgrade of Puerto Rico

February 18, 2014

Dick Larkin, Senior Vice President, Director of Credit Analysis at H.J. Sims was very vocal about S&P’s Puerto Rico rating action. His comments are below:

I am still trying to understand the timing of S&P’s downgrade of Puerto Rico debt to below investment grade. What do I think about it so far? Despite Puerto Rico’s well publicized economic problems and extraordinary efforts to fix its budgetary stress, I do not understand why S&P acted so quickly. The negative rating watch of January 24 was published well after normal trading hours on a Friday night. S&P cited concerns about the Commonwealth’s ability to borrow funds in the credit market, and yet chose to downgrade before Puerto Rico tested the credit market. When did S&P become an expert in credit market access? As far as I know, they are credit raters, not bond traders.

As I have said before, my main concern is that the island’s leadership continues to do all of the right things fiscally to make sure that bondholders are paid on time and in full. With the Governor’s announcement last week of eliminating the projected deficit for 2015, I still believe that long-term Puerto Rico bond investors will be repaid in full. With that major announcement, something that bond credit analysts would deem a significant and positive development, why did S&P’s rating go in the opposite direction? As long as Puerto Rico maintains its current course of fiscal discipline, I don’t give a damn about a rating agency downgrade, especially one that looks so arbitrary. Investors who believe Puerto Rico bonds are only worth 60 cents on the dollar (or less) will sell their bonds at a loss — that is unnecessary and unwarranted.

In 2011, S&P upgraded Puerto Rico’s bond rating from BBB- to BBB, at a time when the budget deficit was three times larger than it is now. Now that the deficit is 66% smaller, and the Commonwealth has announced a plan to eliminate the deficit by the end of the fiscal year, why did S&P choose this time for a downgrade? Finances are improving. Pension funding reforms have been implemented over tough political opposition. Puerto Rico was in the process of planning an orderly re-entrance to the bond market, but never got the chance.

Which experts did S&P consult with to arrive at a conclusion that Puerto Rico would not be able to borrow money in the credit markets? Was S&P swayed by hedge funds that bought bonds at “fire-sale” prices and would be happy to get 70 cents on the dollar for a quick profit? For this new class of investors, hedge fund spokesmen claimed expert status quickly in a market where they had previously no experience. One so-called “expert” was quoted as saying that Puerto Rico’s debt wasn’t worth “10 cents on the dollar”, a ridiculous evaluation for a sovereign government that can control its own destiny with monopolistic power to tax as needed, and cut expenditures as it sees fit.

Rating agencies have been frequently accused of being slow to downgrade, and slow to upgrade. Rating downgrades usually peak after a bond issuer’s worst performance is behind them, and credit factors are on the mend. S&P’s downgrade yesterday meets that description, but the prediction of an inability to access credit is like an arbitrary excuse for a major rating downgrade. It remains to be seen how this will affect Puerto Rico bond prices. In the small amount of trading that occurred after S&P’s downgrade yesterday, prices on Puerto Rico General Obligation debt appeared stable, suggesting that the impact of a rating downgrade has already been priced into the market. Time will tell whether investors accept S&P’s reasons for the downgrade, or choose to ignore the downgrade as irrelevant and ill-timed.

Mr. Larkin says the downgrade appears to be driven by S&P’s concern about Puerto Rico obtaining credit market access to reimburse itself and the Government Development Bank.

Those borrowing plans were scheduled for February, but S&P pulled its rating trigger without seeing how Puerto Rico would fare in a bond sale. Suddenly, S&P’s rating decisions are based on implied market access risk, which is funny considering that S&P has no “skin” in the game: they don’t buy, sell or trade municipal securities, so their expertise on market access has to be questionable.
In addition, it was less than 3 years ago that S&P raised Puerto Rico’s bond rating from “BBB-” to “BBB”, but have now decided to lower its rating when Puerto Rico’s deficit is only 1/3rd the size of that they were facing in 2011.

S&P’s rating concerns have been well advertised, and a little schizophrenic since 2011. In my opinion, Puerto Rico bond investors should not sell their bonds at 60 to 65 cents on the dollar, which are irrationally priced for a sovereign government than can tax and spend at will to manage its finances.

Unless the Government backs off its budget austerity plans to bring spending back in balance with income, Puerto Rico Bond Investors will be repaid, and in full.

Bottom Line: I believe the Puerto Rico Government’s plan to meet its debts as they become due. So my reaction to S&P’s Downgrade: “I DON’T REALLY GIVE A DAMN!”

(Contact Mr. Larkin for a copy of the complete report: