Puerto Rico was downgraded by S&P to junk status on Tuesday, February 4th. Why does this matter? What does that really mean?
As investors look at the market, they notice the credit ratings established by the most reputable companies: Moody’s and Fitch and S&P. A lower credit rating may persuade bond holders to not buy additional bonds or worse, to sell them back. A huge influx of investors selling their bonds could cause a dramatic market crash in Puerto Rico, where the public debt is already over $70 billion dollars (almost four times the amount of Detroit).
Why would institutional investors sell bonds instead of holding out until the market?
Puerto Rico provides a solid investment opportunity to institutions. Municipal debt is tax free and with the high interest rates (more than 11%) they are a great addition to any mutual fund portfolio – an easy way to make your mutual funds look good. According to MorningStar, about 75% of muni-bond mutual funds hold bonds of Puerto Rican debt.
But the risk? Extremely high and gets riskier as their credit rating goes down. This will likely cause institutions to leave the Puerto Rican market until they can clean up their debt, in order to avoid major losses for their clients.
What is the government doing to turn this around?
It’s a little uncertain. They are lobbying every financial institution, government agency, Congress, etc. that can help them either acquire funding or keep investments in place.
The Governor of Puerto Rico, Alejandro Garcia Padilla affirms that the island has “sufficient liquidity” in Fiscal Year 2014 funds to keep them running until June 30th, according to a recent article in Reuters.
This sounds familiar, hasn’t this happened before?
The last time the government of Puerto Rico shut down due to lack of funding was in 2006, what is referred to as the 2006 Budget Crisis. To fund the government, the Puerto Rican Legislature approved a sales tax – which had previously never existed – at 7% total, 5.5% of the tax is split evenly between the COFINA (a fund used to repay the public debt) and State government, up to 1.5% goes to the Municipality. New legislation passed in 2007 requires 6% of the tax goes to the State and 1% goes to the Municipality.
Why can’t Puerto Rico just raise sales taxes to fund the government?
The main issue is higher taxes mean you need more money to buy basic items. With the 16% unemployment rate (2012), -5.8% GDP growth rate, and a requirement to maintain U.S. minimum wage standards it is difficult for businesses to hire more employees and difficult
The Federal Government shut down, what’s the big deal?
It’s a bit different than the Federal Government shut down because the U.S. can borrow much more extensively due to its international standing and significantly stronger credit rating. Puerto Rico’s poor credit rating and lack of Foreign Direct Investment (FDI) prevent it from establishing a solid line of credit. Puerto Rico also doesn’t have as many options for securing FDI as it does not have the freedom to enter into it’s own commerical agreements without the Federal Goverment or sign on to international treaties, etc.
Do they want to be able to sign international treaties?
The current governor Alejandro Garcia Padilla is in the Popular Democratic Party (PPD), which advocates that Puerto Rico should be allowed to enter into international treaties on its own and collect customs duties. Obviously every political party doesn’t always get what it wants (U.S. Republicans want to eliminate ObamaCare – how is that going?), but it is something that is on the forefront of their minds as every possible avenue to collect revenue is relevant.