May 27, 2005
Copyright © 2005 PUERTO RICO HERALD. All Rights Reserved.
Anybody Want To Buy A "Junk Bond"?
Early in the week, Puerto Ricans began to wonder if the promised overpass on that traffic-congested intersection might not be built, the new library not be opened, the expansion wing on an overcrowded school delayed, the flood-control project in their neighborhood shelved indefinitely, or plans for a long-awaited local hospital scrapped altogether.
These and other worrisome predictions flowed from news that Standard & Poor’s (S&P) and Moody’s Investors Service (Moody’s) -- two respected agencies that rate the creditworthiness of borrowers -- had lowered the credit rating of the Government of Puerto Rico Development Bank (GDB). The net effect of the downgrade is that the bonds and other GDB financial instruments will carry a higher interest rate, thereby increasing the overall cost of funding public projects.
Since 1948, the GDB has been the Commonwealth entity that accumulates capital in international financial markets by issuing Government of Puerto Rico Bonds (PR Bonds) to finance many of the island’s long-term infrastructure projects and short-term cash requirements. The GDB is a public corporation governed by directors appointed by the island’s Governor and its financial stability is tied to the economic condition of the island and the fiscal policies of the government. Although the GDB also makes loans to private entities, 65% of its assets reside in public sector obligations.
According to the GDB, Puerto Rico’s public debt is approximately $39 billion, an amount that has grown by 25% in the last 30 months. When measured in "debt ratio" terms — the relationship between public debt and population — Puerto Rico ranks lower than all of the fifty states, except Mississippi.
The S&P rating fell to "BBB" from its previous ranking of "A", established in 2002. The highest possible rating is "AAA," making the new GDB rank four quality steps down from the most desirable position it could hold in the mind of a bond investor. This downgrade followed a report by Moody's which lowered Puerto Rico's general obligation bond rating from "Baa1" to "Baa2." Some economists predict that the downgrading places the reputation of some future GDB offerings to the equivalency of "junk bonds," those obligations that run a high risk of not meeting their offering terms.
PR Bonds have been popular with investors who are subject to federal and state taxes, since the income derived from them is exempt from both. Competing municipal bonds do enjoy a federal income tax exemption but rarely a state exemption, unless the bond is issued by a public entity within that state. Nevertheless, conservative investors shy away from lower-rated municipal bonds as being too risky.
Among the reasons given for the declining credit status of PR Bonds are the island government’s large budget deficit, now estimated at $1.5 billion, and the GDB’s declining cash position. The bank must maintain a minimum level of cash liquidity in order to make periodic interest payments and to fulfill the legal reserve requirements. In the view of the rating agencies, the Puerto Rican government is at the point where it is not able to fund its obligations by tax revenues and must keep borrowing to keep itself afloat. Added to this problem is the looming requirement to pay retirement benefits to the Commonwealth government’s unusually large work force.
This situation is not too different from that of the consumer who regularly uses a credit card to make monthly mortgage payments on the home and to keep his car from being repossessed. As the practice continues, the individual is using more and more income to pay interest on debt and less and less to reduce the loan principal on purchases.
In spite of the downgrade, the S&P report stated that "Puerto Rico’s credit profile remains solid and its strong capital base remains a positive rating factor." Such language offers hope that, if government deficits can be reduced and public spending reigned in, GDB ratings would likely be ranked higher in the future. Evaluators also took comfort from government plans to curtail its borrowing and put its pension liability on a sounder footing.
Perhaps the greatest problem of Puerto Rico’s creditworthiness is its relatively slow economic growth rate, especially when compared with individual states on the mainland. A more robust island economy could produce the tax revenue that the government needs to fund its activities and pay off its debt. This is analogous to the individual who receives a salary increase and uses the additional income to pay-off creditors rather than increasing spending on personal consumption.
Needless to say, the downgrading of Puerto Rico’s creditworthiness produced a whirlwind of political rhetoric, with New Progressive Party (NPP) politicians blaming Popular Democratic Party (PDP) policies over the past two administrations for producing the problem and PDP Governor Aníbal Acevedo Vilá laying blame on the NPP controlled legislature for not approving his reform budget. The lawmakers say that the chief executive’s budget of $9.7 billion does not adequately address the underlying factors for the declining credit ratings and indicate that they are in the process of developing a budget of their own.
Although the credit downgrade is a relatively minor blow to the overall welfare of Puerto Rico, its imposition points up the island’s difficulty in managing its economy and stimulating economic growth. In today’s climate of relatively low interest rates, the estimated ten to fifteen basis points that the lower rating could add to the island’s debt service does not represent a staggering amount in dollars but the amount could rise in an inflationary environment.
The lingering question is whether or not the Puerto Rican government will have the political will to increase tax revenues, cut spending and drastically reduce the number of government employees -- which by some estimates amounts to 35% of the entire island workforce.
What do you think? Will Puerto Rico improve its economic situation in the eyes of the credit rating agencies or will it continue to deteriorate?
Please vote above!
