Fitch Downgrades Puerto Rico GO, Sales Tax, Retirement System & Water Revenue Bonds
NEW YORK--(BUSINESS WIRE)--Fitch Ratings has downgraded the ratings of various Commonwealth of Puerto Rico bonds as follows:
--$13.4 billion Commonwealth of Puerto Rico GO bonds to 'BB-' from 'BB';
--$6.7 billion Puerto Rico Sales Tax Financing Corporation (COFINA) senior lien sales tax revenue bonds to 'BB-' from
--$8.5 billion COFINA first subordinate lien sales tax revenue bonds to 'BB-' from 'A+';
--$2.9 billion Employees Retirement System of the Commonwealth of Puerto Rico (ERS) pension funding bonds to 'BB-' from 'BB';
--$3.4 billion Puerto Rico Aqueduct and Sewer Authority (PRASA) revenue bonds, series A, B, 2012A and 2012B (senior lien) to 'B+' from 'BB+';
--$658 million PRASA Commonwealth guaranty revenue bonds to
'BB-' from 'BB';
--$1.4 billion Puerto Rico Public Building Authority government facilities revenue bonds guaranteed by the Commonwealth to 'BB-' from 'BB'.
The 'B+' rating on PRASA's senior lien revenue bonds is on Negative Watch in light of near-term liquidity requirements dependent on third-party extension of credit or market access.
All other ratings carry a Negative Rating Outlook. The Rating Outlook indicates the direction a rating is likely to move over a one to two-year period. A Rating Watch indicates that there is a heightened probability of a rating change and the likely direction of such change.
The rating actions follow passage of the Puerto Rico Public Corporation Debt Enforcement and Recovery Act, which establishes a restructuring regime for public corporations that may become insolvent. The Act contemplates two procedures for addressing debt obligations. While they are intended to restore solvency over the long-term, both procedures entail debt restructuring that would trigger suspension of debt payments and preclude the timely payment of principal and interest during the pendency of the proceedings.
Fitch downgraded the rating on $8.7 billion of Puerto Rico Electric Power Authority (PREPA) power revenue bonds to 'CC' on June 26 based on the agency's belief that a debt restructuring or default by the Authority is probable in light of the Act, and given the near-term liquidity demands brought on by maturing bank lines of credit and the required repayment of outstanding loans due in July and August 2014.
Fitch does not rate any other Commonwealth appropriation- or special tax-secured debt.
COMMONWEALTH GO & GUARANTEED: 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. Bonds of the Puerto Rico Public Building Authority and PRASA that are guaranteed by the Commonwealth are backed by the Commonwealth's commitment to draw from any funds available in the treasury. The good faith and credit of the Commonwealth is pledged to any such deficiency payments, resulting in a rating that is the same as the Commonwealth's GO bonds.
COFINA: COFINA bonds have a security interest in and are payable from the Commonwealth's sales and use tax. COFINA is an independent governmental instrumentality of the Commonwealth and affiliate of the Government Development Bank for Puerto Rico (GDB) established by specific legislation.
PRASA: PRASA bonds are secured by a gross lien of all authority revenues related to PRASA's combined water and sewer system, as defined in the amended master agreement of trust (MAT), senior to all other debt or expenses of PRASA. Under the provisions of the restructuring act, the gross lien will not be enforceable and is converted effectively to a net lien similar to that under Chapter 9 of the Federal Bankruptcy Code that applies to special revenue bonds.
EMPLOYEES RETIREMENT SYSTEM: The ERS bonds are a limited, non-recourse obligation of the pension system, payable from and secured by a pledge of statutorily required employer contributions to the system.
KEY RATING DRIVERS
COMMONWEALTH GO & GUARANTEED: The Commonwealth has repeatedly demonstrated its focus on bolstering the fundamentals of its general credit, including through continued progress in closing the general fund budget deficit and limiting exposure to public corporation shortfalls. However, the one-notch rating downgrade reflects marginal deterioration in credit fundamentals despite these efforts, with continued economic weakness, revenue underperformance, and challenges to fiscal stabilization efforts, including reform of the teachers' pension system. Although passage of the Public Corporation Debt Enforcement and Recovery Act does not have a direct negative effect on the GO credit, Fitch will closely monitor how passage of the Act affects future market access and commitment to bondholders. Fitch continues to believe that the ultimate success of efforts to put the Commonwealth's finances on a sustainable path will be driven by the performance of the economy. Maintenance of the Negative Outlook reflects both the continued weakness of economic performance and the significant implementation risks to achieving budget balance.
COFINA: Fitch is lowering its rating on the COFINA bonds to the level of the Commonwealth's general credit. Pursuant to Fitch criteria, the amount of credit given to a special tax security is tempered by the risk that the state, faced with extreme financial stress, could exercise its sovereign powers to the detriment of bondholders. Although COFINA bonds are specifically excluded in the Public Corporation Debt Enforcement and Recovery Act, the passage of the Act has substantially increased Fitch's assessment of the risk that the Commonwealth may take steps to the detriment of COFINA bondholders if the Commonwealth considered that a fiscal emergency and its need to provide essential services required legislative action limiting revenues available to COFINA. Such an action would clearly be subject to challenge by bondholders on grounds of unconstitutional impairment of contract similar to the action currently being pursued by bondholders challenging the Act. While bondholders could ultimately prevail on such claims, a default in payment would precede any such outcome. Fitch's ratings reflect the probability of default and do not consider the possible ultimate recovery on a successful impairments claim. As such, in Fitch's opinion, following the change in law a rating distinction between the GO and COFINA credits is no longer warranted. Fitch does not place COFINA debt below the Commonwealth's GO as the agency believes that if circumstances warranted a shift in COFINA revenues to fund the general government, the GO bonds would be equally likely to default. Similarly, there is no longer a rating distinction between the senior and subordinate COFINA liens, as the legal security of each would warrant a higher rating in the absence of Commonwealth risk factors.
PRASA: The downgrade to 'B+' from 'BB+' reflects the downgrade of the Commonwealth's GO rating as well as the implementation of the Act and resulting weakened legal protections of public corporation bondholders (including PRASA bondholders). Further, the downgrade on PRASA's rating reflects the central government's ability to directly or indirectly exert influence that could have adverse implications to PRASA's operations, pointing to a rating that Fitch currently believes can be no higher than that of the Commonwealth GO. Fitch notes that a one-notch distinction below the Commonwealth GO as well as Negative Watch is warranted despite PRASA's currently sound operating position, due to the market challenges PRASA may face over the coming months as it seeks to refinance certain bank lines of credit (LOC) and procure funds for its largely regulatory-driven capital improvement program (CIP).
EMPLOYEES RETIREMENT SYSTEM: The ERS bonds continue to be rated on par with the Commonwealth's GO rating, reflecting the strong legal obligation for employers to make contributions to the system, the long history of timely payment of pension contributions to the system, satisfactory coverage of debt service requirements by pledged revenues, and the general credit quality of the Commonwealth of Puerto Rico, the largest contributor. Puerto Rico Supreme Court decisions provide protection against the Commonwealth legislature lowering the statutory contribution rate, and required employer contributions to the system have increased in recent years. Given that GO bondholders have a claim on Commonwealth revenues senior to contributions due to the pension systems, the rating on the ERS bonds can be no higher than the Commonwealth GO rating. Like COFINA, the ERS was specifically excluded in the Debt Enforcement and Recovery Act.
COMMONWEALTH GO & GUARANTEED: Maintenance of the current rating will require stabilization in economic performance and emergence from the long recessionary period. In addition, failure to show continued progress toward structural balance would pressure the rating. Finally, consistent external market access, including for intra-year general fund cashflow borrowing, is important to the stability of the rating.
COFINA: Going forward, the rating on the COFINA bonds will be sensitive to changes in the Commonwealth's GO rating, to which it is now linked. The rating continues to be sensitive to the performance of the pledged sales tax, although for the foreseeable future the GO rating is expected to be the limiting factor.
PRASA: Difficulty or perceived inability to refinance PRASA's outstanding bank LOCs and access funds for its CIP in the coming months would put negative pressure on PRASA's rating. Also, the rating on PRASA's revenue bonds likely will be influenced by movement of the Commonwealth GO rating for the foreseeable future. Finally, deterioration in financial results that threaten PRASA's ability to achieve at least break-even results would likely result in downward pressure on the rating.
EMPLOYEES RETIREMENT SYSTEM: The rating on the ERS bonds is sensitive to changes in the Commonwealth's GO rating, to which it is linked due to the dominant Commonwealth role in making the employer contributions that secure the bonds. The rating is also sensitive to the maintenance of adequate debt service coverage from such contributions.
COMMONWEALTH GO & GUARANTEED
The 'BB-' rating on Puerto Rico's GO and GO-guaranteed debt reflects demonstrated weakness in the Puerto Rican economy, very high liabilities including outstanding debt and unfunded pensions, still challenged financial operations, and limited financial flexibility.
The Commonwealth's economy has been in recession since 2006. Although some recent information suggests nascent stabilization, albeit at weak levels, results are mixed. Nonfarm employment has been essentially flat in 2014 after declines in 2013. The unemployment rate of 13.8% for May 2014 compares favorably to a peak of 16.9% in May 2010, but incorporates continued drops in the labor force that have once again accelerated year-over-year in recent months. The rate of decline in GDB's monthly economic activity index has slowed notably this year; however, monthly year-over-year declines persist (down 1.1% in May). Fitch sees the economy as a primary driver of future rating direction for the GO credit.
Following a long history of large budget deficits and a reliance on borrowing to fund operations, the general fund gap has been reduced considerably. Most recently, the enacted fiscal 2015 budget reportedly continues strong efforts to bring general fund spending in line with revenues. Fitch believes achieving and maintaining balance will remain challenging, but the commitment of management to this goal appears strong. On the downside, the Commonwealth has had to grapple with significant underperformance in corporate tax revenues in fiscal 2014. The Commonwealth's above-average reliance on corporate taxes remains a concern, given the potential volatility and concentration inherent in these revenue streams, and management is reportedly considering a substantial revision to the revenue system.
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, and the April 2014 Puerto Rico Supreme Court decision finding recent reforms of the teachers' retirement system unconstitutional presented the administration with yet another challenge. The Commonwealth has stated in the past that without reform the teachers retirement system would confront an annual cash flow deficit beginning in fiscal 2020.
Puerto Rico's capital markets access deteriorated steeply in 2013 and the Commonwealth has become increasingly reliant on markets other than traditional municipal investors for external financing. The successful sale of $3.5 billion in GO bonds in March 2014 provided some critical breathing room, but needs remain, including for general fund cashflow borrowing. Reliable external market access is important to long-term stability, and how passage of the Act affects market access will be a significant rating factor for Fitch.
Bonds issued by COFINA are secured by the Commonwealth's island-wide sales and use tax, which became effective on Nov. 15, 2006. The tax was instituted as part of Puerto Rico's 2006 tax and fiscal reform, with COFINA created to refinance appropriation debt of the Commonwealth and thereby free up general fund resources. The Commonwealth expanded leveraging of the revenue stream in 2009 as part of a fiscal and economic package designed to stimulate Puerto Rico's economy and address recurring budget deficits.
Annual debt service coverage by pledged revenues is considerable; based on fiscal 2013 revenues, debt service for the year was covered 5.2x for the senior lien and 1.9x for the first subordinate lien. However, the final maturity of the bonds is very long and the program's rising debt service profile requires some growth in revenues to achieve coverage of later maturities, particularly for the first subordinate lien bonds. Fiscal 2013 revenues would be sufficient to fund debt service without growth through 2056 (senior lien) and 2030 (first subordinate lien). These figures do not include the additional 0.5% recently added to the pledged sales tax to boost coverage or the above-trend growth in fiscal 2014 due to base expansion.
Sales tax collections have proven resilient, increasing since the lowest point in the recession even as the economy has remained weak. Collections fell in only one year during the recession, by 4.5% in fiscal 2009. Total sales tax revenue is up 6.5% year-over-year through May 2014. This is below original expectations for the year, reflecting underperformance of the sales tax changes included in the budget to increase revenues, but still solid growth given continued economic sluggishness.
Strong legal opinions that have been provided with COFINA offerings state that neither the Commonwealth general fund nor Commonwealth GO bondholders have a claim on pledged sales tax revenues until COFINA debt service is fully funded each year. Strong non-impairment language provides some additional assurances to bondholders. Nevertheless, as noted above, in light of the Commonwealth's willingness to change law to the detriment of bondholders with passage of the Public Corporation Debt Enforcement and Recovery Act, Fitch no longer believes that the structure provides sufficient confidence in superior prospects for full and timely payment to warrant a rating above the Commonwealth's GO rating.
PRASA faces potential near-term challenges to takeout expiring LOC from Puerto Rican banks and raise significant funds for annual capital expenditures in light of market concerns relating to the Act and PREPA's deteriorating credit . PRASA currently has drawn $200 million on its bank LOCs and is expected to make draws up to the maximum $350 million prior to expiration of the LOCs in March 2015. The LOCs are solely for interim capital financing and PRASA expects to seek capital market access prior to expiration of the LOCs to fix out the LOCs with long-term debt. Simultaneously, PRASA also hopes to raise sufficient monies to fund its remaining fiscal 2015 - 2016 capital needs and possibly fiscal 2017 capital demands as well. Effecting the long-term takeout of the LOCs and generating capital funding resources for some period of time will be critical to removal of the Negative Watch.
PRASA currently is operationally sound after relying on the commonwealth and GDB to address shortfalls in cash flows for the last several years. PRASA's turnaround was the result of an average 67% rate hike enacted for fiscal 2014. For unaudited fiscal 2014, PRASA generated $1.05 billion in revenues (1% under budget) while spending $691 million towards operations (1% under budget) and incurring debt service costs $28 million under budget. Based on these results and excluding the $86 million in expected rate stabilization fund (RSF) transfers, total debt service coverage (DSC) for the year on a net revenue basis was 1.31x compared to a budgeted 1.19x; if expected RSF transfers are deducted from revenues available for debt service then total DSC was 1.0x for the year.
PRASA has updated its projections through fiscal 2018 and these continue to point to self-sufficient operations, generally favorable operating performance and no additional rate hikes. PRASA's assumptions currently appear reasonable but operating results could be negatively influenced from changes in PRASA's operating environment.
For forecasting purposes, PRASA has assumed that the current preferential electricity rate remains in place but that a planned reduction in the rate in fiscal 2017 does not occur. Based on this change in assumption alone, PRASA plans to divert all surplus revenues for fiscals 2014 - 2015 to its RSF and use these funds to offset the higher than expected energy costs beginning in fiscal 2017 in order to maintain 1.0x DSC and forestall additional rate hikes. In PRASA's prior forecast a portion of surplus revenues were to be utilized for pay-go capital purposes, so this change will result in higher borrowing levels than previously anticipated, albeit only modestly. If PREPA rescinds the preferential rates altogether, the forecast could come under further pressure. Officials have indicated that PRASA would pass-through such costs immediately, but this would place added pressure on PRASA's already burdened rate base.
PRASA's projections prudently do not include $37 million in expenditure cuts mandated by Law 66, which should add some cushion to financial results in the coming years. PRASA has included the corresponding reduced revenues from the commonwealth related to the law's requirement that PRASA provide fiscal emergency contributions to the commonwealth by not charging for services. Fitch notes that even with the expenditure reduction offset, the commonwealth's actions to unilaterally demand assistance from PRASA exposes PRASA to future potential fiscal and operational challenges and limits PRASA's credit fundamentals from previous expectations.
EMPLOYEES RETIREMENT SYSTEM
The ERS pension funding bonds are payable from and secured by a pledge of statutorily required employer contributions to the system. Employer contributions are made by the Commonwealth, associated public corporations, and municipalities. There are 215 contributing employers to the system, but the central government represents about half of total contributions to the system and there are strong interrelationships between other contributors and the central government. No retirement system assets or Commonwealth backstop is available to the bonds and bondholders have no claim on employee contributions.
There is a strong legal obligation for employers to make contributions to the retirement system, a long history of timely payment, and legal protections against the legislature making changes to the system that would reduce the system's funded status. Although subject to appropriation, the contributions are appropriated annually along with appropriations for employee compensation and have a legal payment priority after only public debt. Contributions are made along with payroll as part of an employer's payroll cycle (15 days or monthly), with about 50% of total contributions made through the Commonwealth's Department of Treasury payroll system.
The obligation to pay is a percentage of payroll calculation rather than a fixed dollar amount and, as such, revenues are driven by trends in payroll and the required contribution rate. Required employer contributions to the system have increased in recent years, and the Commonwealth is implementing contribution rate increases to address funding deficiencies in the system. By the end of the 10-year ramp-up period, pension contributions will have increased from 9.275% of covered payroll, the statutorily required employer contribution rate in place from 1990 to 2011, to 20.525%, all of which is pledged to bondholders.
The debt structure is somewhat weak with a very long final maturity (50 years) and rising debt service profile. However, pledged revenues provide satisfactory annual coverage of debt service requirements and the required contribution increases will support coverage going forward. In fiscal 2013, the statutory employer contribution of $425 million provided 2.5x coverage of annual debt service and 0.99x coverage of MADS ($429 million in FY 2028).
The rating on the ERS bonds is the same as that assigned to the Commonwealth's GO bonds, as the Commonwealth is the largest employer contributor and contributions have a strong legal priority. However, given that GO bondholders have a claim on Commonwealth revenues senior to contributions due to the pension systems, the rating on the ERS bonds can be no higher than the Commonwealth GO rating.
Additional information is available at 'www.fitchratings.com'.
Applicable Criteria and Related Research:
--'Fitch Downgrades Puerto Rico Electric Power Auth's Rev Bonds; Maintains Watch Negative' (June 26, 2014);
--'Commonwealth of Puerto Rico' Full Rating Report (March 10, 2014);
--'Fitch Downgrades Puerto Rico Aqueduct & Sewer Auth Senior Revs to 'BB+'; Outlook Remains Negative' (Feb. 18, 2014);
--'U.S. State Government Tax-Supported Rating Criteria' (Aug. 14, 2012);
--'U.S. Water and Sewer Revenue Bond Rating Criteria' (July 31, 2013).
Applicable Criteria and Related Research:
Commonwealth of Puerto Rico
U.S. State Government Tax-Supported Rating Criteria
U.S. Water and Sewer Revenue Bond Rating Criteria