While ratings agencies may have been slow to act on Puerto Rico, here are a few facts for balance:
- Caribbean Business is owned by the former chairman of UBS Financial Services of Puerto Rico, the firm at the center of the Puerto Rico municipal bond calamity.
- Sophisticated municipal investors1 understand that the fact that a bond carries an “investment grade” rating of triple-B does not necessarily mean that it is a safe investment, particularly when compared to triple-A, double-A, and even single-A rated bonds. Triple-B is the lowest rating that qualifies as “investment grade” and it is a very small step from triple-B to junk bond status.
- Generally and historically, sophisticated municipal bond investors hoping to avoid losing money know that triple-B rated issuers are marginal credits to be avoided (when I worked as a municipal bond trader in the 1980’s and until ratings were recalibrated in recent years, triple-B was considered junk in the muni world.) Since 2004, the average rating of all 50 U.S. mainland states was AA+/AA, a full 8 1/2 rating notches above junk bonds (there are 21 ratings “notches”.)
- Moody’s acted in serial fashion to apprise the market of Puerto Rico’s deteriorating credit. As early as July 2006, Moody’s rated P.R.’s general obligation debt Baa3 (one thin notch above “junk” status) and it’s appropriation debt Ba1, i.e., junk bonds. Additionally, the bonds were also on negative watch, so even the higher-rated Baa3 bonds were on the verge of junk in 2006, according to Moody’s.
- While Puerto Rico was relatively briefly rated single-A, in December 2012, P.R. bonds were again downgraded to Baa3 (Moody’s lowest triple-B descriptor) AND kept on negative outlook. By that point, the downward trend in ratings was established and this action meant that even the slightest dip in things economic in P.R. would turn “investment grade” debt into junk bonds. In my opinion, this December 2012 date was when the market was given strong notice by a ratings agency that Puerto Rico would soon be junk.
- As credit conditions worsened and selling bonds on the mainland became difficult, Puerto Rico became more dependent on financing through the issuance of bonds that were sold only to P.R. residents. From 1997 through 2006, “local” P.R. bonds made up 14% of all new issuance. From 2007 through 2012, local bonds composed 48% of all new issues. This means that the Puerto Rico government increasingly relied on selling its debt to a small number of P.R. residents who were already over-concentrated in P.R. securities by 2007, a fact compounded by the over-purchase of local P.R. bonds through leverage. In my opinion, this may be a fact that was missed by both market participants in mainland U.S. AND the ratings agencies.
- Non-sophisticated, retail investors were often not apprised by their brokers that ratings had been lowered, even though these brokers and their employers were often in possession of this information before their customers were.
- A Sophisticated Municipal Market Participant, as defined by the Municipal Securities Rulemaking Board
This post was authored by Mark O. Conner, Principal, Second Chair LLC