Puerto Rico’s bond market and its ratings: How bad it is?
Puerto Rico’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). Moody’s says it affirmed its rating because Puerto Rico’s government has taken substantial steps to raise tax revenues.
Puerto Rico’s bonds are trading as though they have junk ratings. There has been a lot of resulting talk about the disconnect between Puerto Rico’s investment-grade ratings and the yields on its debt.
Part of the increasing yields on Puerto Rico’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. It’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 Moody’s. Moody’s has a ratings group – Moody’s Investors Service – and a Capital Markets Research (CMR) group – a part of Moody’s Analytics. These operate as two legally separate businesses of Moody’s Corporation.
Moody’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 Commonwealth’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 Rico’s five-year EDF measure currently maps to Caa2 on the Moody’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, Moody’s Investors assigned a credit rating of Baa3, which is 8 or 9 rating levels above the Moody’s Analytics ratings. Moody’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 Moody’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 Moody’s, a top notch firm, different methodologies lead to different views of expected default. Everyone believes that Puerto Rico is in dire shape, but it’s a question of degree. Is it “kinda” bad or really bad? Stay tuned.