NEW YORK--(BUSINESS WIRE)--Fitch Ratings has assigned a 'BB' rating to the following general obligation (GO) bonds of the Commonwealth of Puerto Rico:
--Up to $3.5 billion GO Bonds of 2014, Series A.
Fitch has also affirmed the 'BB' rating on $10 billion of outstanding GO bonds of the commonwealth.
The Rating Outlook is Negative.
SECURITY
GO bonds are secured by the good faith, credit and taxing power of the Commonwealth of Puerto Rico. Strong legal provisions for GO debt include a constitutional first claim on commonwealth revenues, including transportation-related and rum excise tax revenues that are dedicated to specific authorities and other bonds. The commonwealth cannot file for bankruptcy.
KEY RATINGS DRIVERS
WEAK ECONOMY THE KEY CREDIT FACTOR: Puerto Rico's economy has been in recession since 2006. Although some recent information suggests nascent improvement, results are mixed. Fitch believes that the ultimate success of efforts to put the commonwealth's finances on a sustainable path will be dictated by the performance of the economy.
DEBT AND RETIREE BENEFIT LIABILITIES HIGH: Puerto Rico's bonded debt levels and unfunded pension liabilities are very high relative to U.S. states, with a large amount of outstanding debt issued for deficit financing purposes. Pension funding will remain exceptionally low even with the significant pension reform effort undertaken by the current administration.
BUDGET IMPROVED, BUT CHALLENGES REMAIN: Following a long history of significant budget deficits and a reliance on borrowing to fund operations, the general fund gap has been reduced considerably and the governor recently announced the intent to balance the budget next year, one year earlier than previously expected. Fitch believes achieving and maintaining balance will remain challenging.
FISCAL MANAGEMENT EFFECTIVE AND COMMITTED: The current administration has made significant progress in addressing longstanding credit issues and responded quickly and decisively to challenges. Fitch believes the commitment to achieving fiscal balance and honoring commitments to bondholders remains strong.
FINANCIAL FLEXIBILITY CONSTRAINED: The commonwealth's capital markets access deteriorated steeply in 2013 and non-investment-grade ratings potentially limit the market available for the commonwealth's debt going forward. Reliable external market access in line with market norms is important to long-term stability.
LINK TO U.S. A CREDIT POSITIVE: Puerto Rico's status as a commonwealth of the U.S. and strong linkages to the U.S. economy are credit strengths, although the application of U.S. law and minimum wage standards may reduce competitiveness in some areas.
RATING SENSITIVITIES
MARKET ACCESS: The current rating assumes that the commonwealth will be able to execute a sizable transaction in the near term to bolster liquidity. An inability to access the market would be a significant credit concern and cause for a downgrade.
EVIDENCE OF ECONOMIC STABILIZATION: Maintenance of the current rating will require stabilization in economic performance and emergence from the long recessionary period.
ACHIEVABILITY OF BUDGET TARGETS: Failure to show continued progress toward structural balance would pressure the rating.
CREDIT PROFILE
The 'BB' rating on the bonds reflects demonstrated weakness in the Puerto Rico economy, very high liabilities including outstanding debt and unfunded pensions, challenged though improving financial operations, and limited financial flexibility.
The current transaction, the vast majority of which will replace existing debt rather than adding to the commonwealth's debt load, is designed to bolster liquidity at the GDB and remove potential near-term liquidity stresses. Fitch's rating assumes that the commonwealth will be able to address liquidity pressures through such borrowing, and the inability to do so could result in significant credit deterioration.
Puerto Rico's current management has repeatedly shown its ability and willingness to take quick action to address financial challenges and external market concerns, much of which has required legislative action. However, underlying the need for these measures is the very difficult economic, financial, and market situation that management continues to confront.
ECONOMY
Although Puerto Rico's employment cycles historically have been generally in line with those of the U.S., more recently the commonwealth's economy fell into recession in 2006, long before the U.S. recession started, and has yet to rebound. Initial signs of recovery in 2012 now appear to have been more a reflection of economic stimulus than underlying growth and subsequent economic performance has been weak.
Since the start of the recession, Puerto Rico has lost more than 10% of non-farm employment, and population has been declining. Nonfarm employment was down 2.6% year-over-year in December 2013, an improvement from prior months, but the unemployment rate remained a high 15.5%. The Government Development Bank for Puerto Rico (GDB) Economic Activity Index (EAI), an indicator of the general level of economic activity, was down year-over-year every month in 2013, with the pace of decline accelerating in the first half of the year and stabilizing in the latter half. The December 2013 EAI was 5.2% below December 2012. The U.S. Bureau of Labor Statistics is scheduled to release revised employment statistics later this month; any change in historical numbers would have a direct effect on the EAI, as employment is one of four variables for that statistic.
Puerto Rico's status as a commonwealth of the U.S. and strong linkages to the U.S. economy are a positive credit factor. Federal transfer payments represented 25% of 2012 personal income, mostly in the form of entitlements such as social security and Medicare. This serves as a stabilizing force but is also illustrative of the comparative weakness of the overall economy.
As it struggles to emerge from a prolonged recession, Puerto Rico faces a longer term question of how to grow and diversify its economy, increase employment and workforce participation levels, enhance wealth and income, and address longer term structural contraction in its existing pharmaceutical and electronic producing industries. The ultimate test will be whether or not Puerto Rico is able to find a sustainable path to the economic growth that is necessary to support the commonwealth's high debt levels and other long-term liabilities, as well as to achieve and maintain a structurally balanced budget.
The commonwealth is focused on economic development, and has had some notable successes. However, making the current situation more challenging, historical economic performance reflects extensive use of federal and commonwealth selective tax exemptions, financial and tax incentives, development loans, and other economic initiatives. In addition, government austerity and recent tax and utility rate increases could have a dampening effect on economic performance.
FINANCES
One of the most notable aspects of Puerto Rico's recent credit history has been the efforts to restructure fiscal operations and bring structural balance to the budget in the context of a weak economy. Although the commonwealth has thus far failed to meet the goal of budget balance, the efforts have yielded significant results. The general fund deficit has been reduced from more than 40% of general fund revenues in fiscal 2009 to a budgeted 9% in fiscal 2014, even with increased funding for pensions in the current fiscal year. Moreover, the administration has reduced the fiscal 2014 deficit forecast from $820 million to $650 million, and intends to present a balanced budget proposal for fiscal 2015, which begins on July 1. This is one year earlier than previously promised.
The commonwealth's tax structure has changed repeatedly and significantly as part of various fiscal and economic policy schemes, making it difficult to conduct robust trend analysis and judge the degree of the relationship between particular economic and revenue results. The general fund now relies on three main revenue sources: the personal income tax (30% of projected fiscal 2014 revenues), corporate income tax (26%), and the special 'Act 154' excise tax on transactions between manufacturers and distributors that are part of the same holding group (20%). The commonwealth sales tax also generates significant revenues, but the general fund receives sales tax revenue only after the amount needed for COFINA debt service and as such only 6% of general fund revenue is from this source.
Fiscal 2014 revenues through February are reported up 10% year-over-year, reflecting tax increases enacted as part of the current-year budget. The January 2014 general fund revenue forecast revision, while unchanged in aggregate at $9.5 billion, reflects an even larger reliance than previously budgeted on corporate taxes, which have been overperforming estimates. The sales tax changes included in the budget have failed to produce all of the expected additional revenues.
Fitch believes that meeting the goal of structural balance remains challenging, and notes the failure of plans under prior administrations. The commonwealth has to address extensive expenditure demands, with more responsibility for local functions than U.S. states have, and there are material spending increases embedded in the budget. However, efforts of recent years have resulted in significant progress in rationalizing the commonwealth's fundamental financial position, and the commitment and effectiveness of the current administration appears strong.
DEBT & PENSIONS
Fitch's calculation of commonwealth net tax-supported debt as of June 30, 2013 is $47 billion, a very high 76% of personal income. Elevated bonded debt levels reflect extensive use of deficit financing as well as the consolidated nature of the central government's role in Puerto Rico. The commonwealth has a complex debt structure including GO, sales tax, guaranteed, and public corporation debt. The often-cited figure for Puerto Rico's debt - $70 billion - includes not only debt supported by commonwealth tax revenues but also debt of the electric and water and sewer utilities and other revenue-supported debt that is not the obligation of the central government.
Pension funding has been a longstanding credit challenge for Puerto Rico. Funding is exceptionally low and will remain so even with the significant pension reform effort undertaken by the current administration. The commonwealth passed a comprehensive pension reform of the employees retirement system in 2013. The overhaul did not attempt to improve the actuarially determined funded status, which will remain close to zero for many years, but rather focused on achieving a predictable and manageable annual funding scheme. Importantly, the commonwealth quickly received Puerto Rico Supreme Court validation of the reform, eliminating the potential for legal challenge. Reform with similar goals was enacted for the teachers system late last year, and legal challenges are currently being considered by the Supreme Court.
LIQUIDITY
Puerto Rico for many years relied on market solutions to fund operations and refinance debt for current-year budget savings. With a confluence of negative events, related to both the commonwealth specifically and the municipal market in general, Puerto Rico's market access deteriorated steeply in 2013 despite the significant actions taken by the current administration to address longstanding challenges. As a result, Puerto Rico became increasingly dependent on relatively short-term, privately placed borrowing to meet its funding requirements. This in turn created its own liquidity pressure, and a reliance on the resources of GDB, which has played an increasingly significant role in commonwealth finances.
Recent downgrades of the commonwealth's debt to non-investment-grade levels triggered potential new liquidity demands of about $1 billion, although the commonwealth has worked with relevant counterparties to mitigate the impact and expects to take out variable-rate debt and fund swap termination payments with proceeds of the current borrowing. The administration has also taken a variety of steps to improve GDB liquidity in recent months.
The current borrowing is expected to alleviate liquidity pressures, a significant credit factor for Fitch. Fitch will closely review the results of the transaction to determine its impact on GDB liquidity and the commonwealth's overall financial flexibility and debt service burden, noting that the vast majority of the debt will refund existing obligations.
Additional information is available at 'www.fitchratings.com'.
In addition to the sources of information identified in Fitch's Tax-Supported Rating Criteria, this action was additionally informed by information from the underwriters.
Applicable Criteria and Related Research:
--'Fitch Downgrades Puerto Rico GO and Related Debt Ratings to 'BB'; Outlook Negative' (Feb. 11, 2014);
--'Tax-Supported Rating Criteria' (Aug. 14, 2012);
--'U.S. State Government Tax-Supported Rating Criteria' (Aug. 14, 2012).
Applicable Criteria and Related Research:
Tax-Supported Rating Criteria
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=686015
U.S. State Government Tax-Supported Rating Criteria
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=686033
Additional Disclosure
Solicitation Status
http://www.fitchratings.com/gws/en/disclosure/solicitation?pr_id=822457
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