Puerto Rico Municipal Bonds May Be Officially Rated as Junk Potentially Increasing Losses in Municipal Bond Funds That Hold Puerto Rico Debt

Fitch, a nationally recognized statistical credit ratings group, said it may downgrade Puerto Rico municipal bonds to junk bond status by mid-2014. Fitch, Standard & Poor’s and Moody’s currently rate Puerto Rico municipal bonds at BBB-, the lowest investment grade bond rating. Fitch, Moody’s, and Standard & Poor’s all have placed a negative outlook on Puerto Rico debt.

Fitch was the first statistical rating organization to use the now familiar “AAA” to “D” ratings scale. Bonds with a high credit quality are rated as AAA and AA. Bonds with ratings of A and BBB are considered to be of medium credit quality. A movement from BBB to BB would reclassify the bond from investment grade to junk status. In the junk bond category, bonds may be rated as BB, B, CCC, CC, C, etc. and are considered low credit quality.

If Fitch reclassifies Puerto Rico municipal bonds as junk, it will most likely influence the prices of the municipal bond funds that hold Puerto Rico debt. As of June 2013, Puerto Rico and its agencies held approximately $70 billion in debt. Currently, more than one-third of the United States bond funds containing municipal bonds invest at least 5% of their assets in Puerto Rico municipal bonds.

Fitch said its potential downgrade to junk bond status would apply to:

• Puerto Rico’s general obligation bonds;
• Revenue bonds issued by the Puerto Rico Building Authority that are guaranteed by the Commonwealth of Puerto Rico;
• Revenue bonds issued by the Puerto Rico Aqueduct and Sewer Authority and guaranteed by the government of Puerto Rico; and
• Pension funding bonds issued by the Employees Retirement System of the Commonwealth of Puerto Rico.

The repercussions of a downgrade to non-investment grade will be highly problematic for Puerto Rico and also adversely affect bond prices for investors.

Fund management companies Blackrock, the world’s largest asset manager, and Pacific Investment Management Co. (“Pimco”) told Bloomberg that if Puerto Rico loses its investment-grade status, it could place the entire $3.7 trillion municipal market at risk.
According to Bloomberg, even though most municipal bond funds are not required to liquidate issues that are downgraded to junk status, the downgrade would likely prompt investors to withdraw from the municipal bond funds. A spokesman for Blackrock estimates that fund managers would likely liquidate the higher quality bonds in the fund to generate cash for those withdrawals.

Read more information on Puerto Rico municipal bonds here.