Puerto Rico’s bond market and its ratings: How bad it is?
Puerto Ricoâ€™s creditworthiness continues to decline as its economy contracts, but its ratings have remained at the Baa3 and BBB- level (the lowest investment grade rating). Moodyâ€™s says it affirmed its rating because Puerto Ricoâ€™s government has taken substantial steps to raise tax revenues.
Puerto Ricoâ€™s bonds are trading as though they have junk ratings. There has been a lot of resulting talk about the disconnect between Puerto Ricoâ€™s investment-grade ratings and the yields on its debt.
Part of the increasing yields on Puerto Ricoâ€™s debt is due to a shrinking investor base. Several large structural shifts took place as the local Puerto Rico market blew up, killing demand for bonds from investors. U.S. municipal mutual funds had substantial redemptions and were often forced to liquidate some of their Puerto Rico holdings. Even more stress was added by the announcements of SEC investigations into the disclosure by mutual funds of the risk of these securities. Itâ€™s a perfect storm of regulatory and market challenges for Puerto Rico.
But nowhere is the disconnect between a credit rating and the market clearer than at Moodyâ€™s. Moodyâ€™s has a ratings group – Moodyâ€™s Investors Service – and a Capital Markets Research (CMR) group – a part of Moodyâ€™s Analytics. These operate as two legally separate businesses of Moodyâ€™s Corporation.
Moodyâ€™s Analytics CMR, using market-derived signals, writes about Puerto Rico (emphasis mine):
Market-based probabilities of default for Puerto Rico have deteriorated notably in recent months. The Commonwealthâ€™s five-year cumulative CDS-implied EDF (Expected Default Frequency) credit measure, for example, rose from 10.42 percent in early September to 15.65 percent today [graph at the top of this post].
Puerto Ricoâ€™s five-year EDF measure currently maps to Caa2 on the Moodyâ€™s Investors Service rating scale; its one-year EDF measure, at 3.05 percent, to Caa3. Both of these metrics exceed those of all US states and all sovereign entities in our data set except Argentina.
Meanwhile, Moodyâ€™s Investors assigned a credit rating of Baa3, which is 8 or 9 rating levels above the Moodyâ€™s Analytics ratings. Moodyâ€™s Investors Baa3 rating maps to a historical default rate of 0.37 percent for bonds outstanding for 10 years, as seen in this chart (page 11) versus a Moodyâ€™s Analytics estimated default probability of 15.65 percent.
Both methodologies are useful and help inform investors. There is a lot of uncertainty about the credit quality of Puerto Rico. Even within Moodyâ€™s, a top notch firm, different methodologies lead to different views of expected default. Everyone believes that Puerto Rico is in dire shape, but itâ€™s a question of degree. Is it â€śkindaâ€ť bad or really bad? Stay tuned.