NEW YORK--(BUSINESS WIRE)--Fitch Ratings has downgraded the ratings of the following Commonwealth of Puerto Rico debt to 'BBB-' from 'BBB+:
--$10.6 billion Commonwealth general obligation (GO) bonds;
--$1.38 billion Public Building Authority government facilities revenue bonds guaranteed by the commonwealth;
--$658 million Puerto Rico Aqueduct and Sewer Authority (PRASA) commonwealth guaranty revenue bonds;
--$2.948 billion Employees Retirement System of the Commonwealth of Puerto Rico pension funding bonds.
The Rating Outlook is Negative.
SECURITY
The GO bonds are a full faith and credit obligation of the Commonwealth of Puerto Rico that benefit from a constitutional first claim on commonwealth revenues. The ratings on the Building Authority and PRASA bonds reflect the guaranty of the commonwealth's full faith, credit, and taxing power. The pension funding bonds are payable from and secured by a pledge of statutorily required employer contributions to the system; the commonwealth is the largest contributor.
KEY RATINGS DRIVERS
SIGNIFICANTLY INCREASED CHALLENGES: The downgrade to 'BBB-' reflects economic and revenue underperformance that Fitch believes has significantly increased the size of the operating imbalance for the current fiscal year and the gap presented to the commonwealth as it develops a budget for 2014. Fitch does not believe that structural budget balance will be achieved in fiscal 2014, and meeting this goal will remain challenging thereafter.
WEAK ECONOMIC PERFORMANCE: The commonwealth's economy is limited but closely linked to that of the U.S. The recession in Puerto Rico started earlier, was deeper, and lasted longer than the U.S. national recession. After signs of stabilization in 2012, recent performance has weakened and prospects for near-term growth are limited.
VERY HIGH LIABILITIES: Puerto Rico's bonded debt levels are exceptionally high and pension system assets are expected to be depleted in the foreseeable future. These high liabilities both limit Puerto Rico's ability to use additional leveraging for capital improvements or as a budget solution and create spending pressures that will be difficult to absorb within slowly growing revenues.
PENSION REFORM A NECESSITY: Pension assets are nearing depletion and will expose the government to higher costs for direct benefit payments in the absence of wide-ranging pension reform. The legislature is considering contribution and benefit reforms that address the impending cash flow impact of low system funding levels and prospects for passage appear good.
IMPROVED FINANCIAL MANAGEMENT: Commonwealth financial operations historically have been weak with a record of large budgetary and GAAP deficits, overestimation of revenues, unfunded overspending, and a reliance on borrowing to meet budgetary gaps. The prior administration made progress in restructuring fiscal operations even while it did not achieve the goal of structural balance. The current administration is continuing the focus on improved financial responsibility.
RATING SENSITIVITIES
Stabilization at the current rating level would be based on substantial progress toward budgetary balance that does not rely on debt restructuring for fiscal relief.
Enacting pension reform that supports the solvency of the pension system, while controlling the demands that pensions place on the budget, is assumed at the current rating level.
CREDIT PROFILE
Puerto Rico's GO rating reflects the limited nature of its economy, its strong ties to the U.S., a history of weak financial operations, and very high liabilities including outstanding debt and unfunded pensions. 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.
STRUCTURAL BALANCE DELAYED
Despite aggressive cost cutting and other fiscal restructuring measures over the past four years, economic recovery and budget balance have proven elusive. Fitch has noted steady progress in stabilizing the commonwealth's finances; however, with a reduction in near-term expectations for the economy and revenue underperformance in the current fiscal year to date, the budget challenge facing the new administration has expanded considerably compared to original estimates. The current-year deficit is now projected to be well above the $1.1 billion originally forecast (including debt refinancings for budget relief). While the administration has identified gap closing solutions for a significant portion of the current year deficit, a sizeable $490 million gap is estimated to remain. Fitch anticipates that it will be difficult to close this gap during the few remaining months of fiscal 2013 and additional borrowing from the Governmental Development Bank of Puerto Rico (GDB) will be the most likely contingency.
With only tepid growth in revenues anticipated and additional spending pressure, the administration is also likely to face a considerable budget gap for fiscal 2014. Spending pressures include required statutory increases in pension contributions as well as incremental pension contributions dictated by the administration's proposed pension reform, discussed below. The administration has also made a commitment to reducing reliance on debt restructuring for fiscal relief, which will bring a portion of the expense for general obligation debt service into the general fund budget.
Some revenue enhancement will be derived from an agreement with local manufacturers to increase and stabilize the Act 154 excise tax on transactions between manufacturers and distributors that are part of the same holding group. Maintaining this excise tax at 4% rather than reducing according to the original statutory plan is expected to generate an additional $600 million annually through its expiration in 2016. Other revenue enhancements and additional expenditure controls are expected to be included in the governor's budget proposal to be released in the next several weeks. While Fitch does not expect the fiscal 2014 budget to be structurally balanced, the rating assumes substantial progress toward structural balance.
PENSION REFORM
The legislature is considering major pension reform proposed by the governor that would address future cash flow shortfalls over the remaining life of the now-closed Employees Retirement System (ERS). The proposal includes steps to increase contributions and delay the depletion of system assets, reduce future liabilities by moving all employees still in the defined benefit plan to a hybrid defined benefit/defined contribution plan, reduce future benefits in part by eliminating or reducing special law benefits, increase the retirement age, and increase employee contributions to the plan. Even if fully implemented, the pension reform focuses on addressing future cash flow deficits, not raising the pension's actuarially determined funded level, which is likely to remain at or close to zero. Further, even with these substantial changes, the administration projects an ongoing cash flow deficit that it has indicated it will begin to fund within the general fund budget. Enacting pension reform in line with the governor's proposal is incorporated into the rating. Although there is some risk of legal challenge, which would not be unusual with pension reform, successful implementation can potentially be a future stabilizing factor.
HIGH DEBT LEVELS
Puerto Rico's debt levels are very high, partially reflecting the consolidated nature of the central government's role, and have increased as the commonwealth has used deficit financing as part of its fiscal stabilization plan. The commonwealth utilizes a complex debt structure that includes GO, sales tax, guaranteed, and public corporation debt, and has relied heavily on borrowing under its various bonding programs in order to fund operations. Although such borrowing has been reduced, reliance on capital markets to refinance debt for current-year budget savings introduces risk to operations and increases the already high debt burden. The commonwealth benefits from its relationship with the GDB, which provides a degree of flexibility and liquidity.
ECONOMIC GROWTH NOT GAINING TRACTION
As it struggles to emerge from the 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 contraction in its existing pharmaceutical and electronic producing industries. The ultimate test of the success of future policy will be whether or not Puerto Rico is able to find a sustainable path to economic growth, 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.
Additional information is available at 'www.fitchratings.com'. The ratings above were solicited by, or on behalf of, the issuer, and therefore, Fitch has been compensated for the provision of the ratings.
Applicable Criteria and Related Research:
--'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
ALL FITCH CREDIT RATINGS ARE SUBJECT TO CERTAIN LIMITATIONS AND DISCLAIMERS. PLEASE READ THESE LIMITATIONS AND DISCLAIMERS BY FOLLOWING THIS LINK: HTTP://FITCHRATINGS.COM/UNDERSTANDINGCREDITRATINGS. IN ADDITION, RATING DEFINITIONS AND THE TERMS OF USE OF SUCH RATINGS ARE AVAILABLE ON THE AGENCY'S PUBLIC WEBSITE 'WWW.FITCHRATINGS.COM'. PUBLISHED RATINGS, CRITERIA AND METHODOLOGIES ARE AVAILABLE FROM THIS SITE AT ALL TIMES. FITCH'S CODE OF CONDUCT, CONFIDENTIALITY, CONFLICTS OF INTEREST, AFFILIATE FIREWALL, COMPLIANCE AND OTHER RELEVANT POLICIES AND PROCEDURES ARE ALSO AVAILABLE FROM THE 'CODE OF CONDUCT' SECTION OF THIS SITE. FITCH MAY HAVE PROVIDED ANOTHER PERMISSIBLE SERVICE TO THE RATED ENTITY OR ITS RELATED THIRD PARTIES. DETAILS OF THIS SERVICE FOR RATINGS FOR WHICH THE LEAD ANALYST IS BASED IN AN EU-REGISTERED ENTITY CAN BE FOUND ON THE ENTITY SUMMARY PAGE FOR THIS ISSUER ON THE FITCH WEBSITE.