Muni investors were sitting on pins and needles Tuesday morning and it was not all about the outcome of the USA-Belgium World Cup match. Weighing on their minds was the question of whether or not, in the wake of last week’s events, PREPA would be making payment for the July 1st coupon on its debt. A non-payment, of course, would constitute the largest muni default to date, eclipsing the Detroit case. It would also send a clear message that PREPA intends to seek imminent relief under the new “bankruptcy law” for public corporations.
Early in the day, a Bloomberg article reported that the bond Trustee (US Bancorp) had the money for payment but had to decide whether or not to withhold it, depending on PREPA’s next course of action. Rumors then swirled throughout the day, as payment was first confirmed, then denied and then confirmed again. Final confirmation was not received until the close of business, with this statement from the GDB: “The GDB Chairman confirmed that all GO, PREPA and HTA bond payments maturing today, July 1, 2014, were made today. $721,971,213 was paid to service GO bonds and $ $417,556,563 to service PREPA bonds.”
The problem is, by the time the rating agencies finally act, the market has already rendered its verdict and some kind of remedial action has already been taken with regard to the affected entities.
Yet, as soon as the market breathed a sigh of relief, Moody’s came out and announced massive across-the-board downgrades on all Puerto Rico debt.
At what point does the rating agencies’ backward-looking methodology start to confuse rather than help the market? As regular readers of this column know, for several months now, we’ve been arguing that any credit that’s in such severe liquidity straits as PREPA shouldn’t be rated anywhere near investment grade and should be closer to the lowest junk level. Following passage of the public corporation restructuring law last week, the rating agencies finally reacted and took what one market observer called a “chainsaw” approach to all the PR ratings.
Moody’s did exactly that yesterday afternoon. It downgraded PR GO to B2 from Ba2 and COFINA Sr lien and Sub Lien to Ba3 and B1, respectively. PREPA was cut to Caa2 from Ba3, PRASA to Caa1 from Ba3 and PRHTA Sr lien to Caa1 from Ba3.
Moody’s primary rationale? “Puerto Rico’s new law marks the end of the commonwealth’s long history of taking actions needed to support its debt. It signals a depleted capacity for revenue increases and austerity measures, and a new preference for shifting fiscal pressures to creditors.”
Yet Moody’s seems to be contradicting itself to some extent when it confirmed Assured Guaranty’s rating today: “Given the meaningful downward credit migration among Puerto Rico issuers, we view the probability of a potential Puerto Rico default as substantially less remote than was the case several months ago, though there remains significant uncertainty as to the potential loss severity among the various Puerto Rico related issuers if a default (or defaults) were to occur.” So, why is Assured’s creditworthiness not affected by the higher probability of default on all PR debt?
The problem is, by the time the rating agencies finally act, the market has already rendered its verdict and some kind of remedial action has already been taken with regard to the affected entities. While institutional investors are usually savvy enough to recognize this, retail investors are usually the ones who may end up getting hurt as they react in panic to the headlines.
The Commonwealth of Puerto Rico was also confused by Moody’s action, and understandably so. The Padilla Administration obviously feels it’s doing its best to deal with a difficult situation, and it must be frustrated to see its efforts be rewarded with another downgrade (the Spanish word for downgrade, “degradacion”, certainly sounds a lot more humiliating than in English). That said, the Governor’s knee-jerk reaction to threaten to sue Moody’s is rather silly and not very helpful. He really should let the market decide whether or not Moody’s ratings are still relevant.
The COFINA downgrade did come as a surprise to us and we think it’s wholly unwarranted, based on what we currently know. Unfortunately, it does bring into question the Commonwealth’s ability to bring to market the next COFIM deal, thereby raising the “market access” issue all over again.
Not surprisingly, after last week’s rally, the price on PR G.O. 8.00% of 2035 has fallen back to its previous low, around the 84 level, as investors fret about the potential contagion effect of a public corporation bankruptcy on all PR debt. Others have expressed skepticism about the success of the Commonwealth so-called “ring-fencing” efforts.
Those who scoff at PR’s ring fence strategy and are advocating a more “holistic” approach to restructuring PR’s debt should stop and consider this: is it really in anyone’s interest, from investors to bond insurers, to blow up the entire PR debt complex just for the sake of a legal argument? Why turn a $9 billion problem into a $70 billion problem if you don’t have to?
Frankly, we’re also a little puzzled that many market observers, including the rating agencies, have interpreted the Public Corporation Debt Enforcement & Recovery Act as a weakening of Puerto Rico’s willingness to pay. After all, the Commonwealth is trying to protect its G.O. obligations by trying to isolate them from the public corporation debt. Isn’t that indicative of a strong, albeit selective, “willingness to pay?”
Furthermore, if “willingness to pay” has been the main reason for the rating agencies to maintain PR at investment grade level, up until only a few months ago, then their methodology needs a serious reboot.
We’ve always believed that one should never buy bonds based solely on the issuer’s perceived “willingness to pay.” At the end of the day, everyone acts in their best economic interest. If a project or entity is not economically viable, the issuer’s “willingness to pay” can fade quickly. MuniNetGuide’s own Richard Ciccarone put it most succinctly: “A better way to approach the “willingness to pay” issue is to make sure that the credit is either economically viable or politically pragmatic.” By either standard, PREPA has been a doomed credit for quite a while.
On that note, we do want to wish you a great Fourth of July. Do relax and get a lot of rest: we may have more credit fireworks to deal with in the second half of the year. And, ultimately, more potential investment opportunities.
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