The bonds, which have been paying ever-larger yields as the territory has sunk deeper in debt, have long been attractive because their earnings are free of state and federal taxes.
With outstanding obligations that dwarf Detroit’s $18 billion, Puerto Rico could have an impact on the larger municipal bond market. Although the commonwealth is barred from filing for bankruptcy and leaders have undertaken serious austerity measures — raising taxes and slashing pensions — the specter of default of some of its estimated $70 billion in debt remains a concern.
“The full implications of this downgrade are a real unknown,” said Matt Fabian, managing director of Municipal Market Advisors, a firm that tracks the municipal bond market. The question, he said, is “How will bondholders react?”
If the S&P action is followed by similar moves by rating agencies Moody’s or Fitch, Puerto Rico could be forced to put up cash to get out of derivative contracts and other financing deals that might be terminated by the change in its creditworthiness, Fabian added.
S&P said its downgrade is related to Puerto Rico’s “reduced capacity to access liquidity” from its Government Development Bank. Beyond moving the general obligation bonds to junk status, S&P also downgraded to speculative levels bonds secured by budget appropriations and others supporting its employee retirement system.
The move to downgrade Puerto Rico’s debt came despite a concerted effort by government officials to alter the island’s fiscal trajectory.
In the past year, the government has pushed through reforms trimming pensions for teachers and other government employees. Meanwhile, tax revenue is up and the island said it has plans to introduce a balanced budget in 2015 — which would mark the first time in many years Puerto Rico’s budget has not been propped up by borrowing.
“These measures were evidently not enough to sway the rating agency,” said Candice Lee, a Morningstar analyst.
Still, she said, given the big sell-off of bonds triggered by news of Puerto Rico’s deep fiscal problems last year, “it remains unclear whether the risk of default has already been priced into Puerto Rico general-obligation bonds, which were yielding well over 10 percent at the 10-year maturity range.”
The impact of the downgrade could become clearer shortly because Puerto Rico needs to come to market in the coming weeks to borrow money to fill accumulated budget deficits.
Puerto Rico’s top economic officials said they planned to persevere with their austerity efforts, as well as strategies for boosting tourism and lifting the island’s sagging job market.
“While we are disappointed with Standard & Poor’s decision, we remain committed to the implementation of our fiscal and economic development plans. We believe the investment community will recognize the positive impact of the reforms that the [Gov. Alejandro Javier] Garcia Padilla Administration has enacted in due course,” Treasury Secretary Melba Acosta Febo and David H. Chafey, president of the island’s Government Development Bank, said in a written statement.