With a few embarrassing exceptions, credit-rating companies tend to issue downgrades after the dangers of default have become obvious to everyone.
Thus we have Standard & Poor's taking Puerto Rico's general-obligation debt down a level to BB+ (below investment grade, or junk) yesterday after the commonwealth's 10-year GO debt lost about 30 percent of its value over the summer and yields had doubled to about 10.1 percent since the end of May. (As an aside, S&P removed Puerto Rican bonds from its National AMT-Free Municipal Bond Index last week.) For comparison, 10-year yields on dollar-denominated bonds issued by Turkey, which is supposedly in the midst of an economic crisis, now yield about 5.5 percent, up from about 3.3 percent at the end of May.
The recent surge in yields occurred as traders started worrying that monetary tightening by the Federal Reserve would roil financial markets. But Puerto Rico has been struggling with high debt and low growth for years.
The U.S. federal government hasn't done much to help, with the notable exception of a clever tax rebate that effectively transfers money from the Treasury to the Puerto Rican government. Official indifference is consistent with the approach to other beleaguered borrowers on the mainland such as Detroit and Harrisburg, Pennsylvania.
The downgrade itself probably won't have much economic impact, but there is a question about what might happen if Moody's Investors Service and Fitch Ratings issue their own downgrades. That might force selling by investors who have mandates preventing them from holding junk-rated debt, although there is good reason to think that many of those entities have already dumped most of their Puerto Rican holdings. Moreover, hedge funds and other distressed-debt investors might pick up some of the slack in the event that anyone is forced to sell.
A larger concern is whether Puerto Rico's ability to fund itself in the capital markets will be further impaired. If there isn't enough cash on hand to make existing debt payments, the island may be forced to default or restructure. This concern was part of what motivated S&P's downgrade in the first place.
Puerto Rico doesn't need to raise money now, but the Wall Street Journal reported over the weekend that it has been working to raise about $2 billion from hedge funds and other distressed investors. In addition to the high borrowing cost, estimated at 10 percent, these new bonds may also have stricter covenants than Puerto Rico's other debts. How much harder will it be for the island to borrow once its debt is deemed junk by all three raters?
Making matters worse, the ratings cut will push swaps counterparties to demand additional collateral and force some existing interest payments to be accelerated. According to Nuveen Investments, "the downgrade to below investment grade could result in additional liquidity demands of approximately $1 billion." The Puerto Rican government is aware of these risks and has been negotiating with its creditors to avoid having to pay this money up-front.
The island's troubles -- and the troubles of people who own Puerto Rican bonds -- probably are far from over.
(Matthew C. Klein is a writer for Bloomberg View. Follow him on Twitter.)
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