Selling Puerto Rico Cofina 3.0
HJ Sims Larkin “I think Cofina 3.0 would have to come around 7%. People have to lose their sense of hysteria re PR” #bbmunis
— Cate Long (@cate_long) November 6, 2013
Richard Larkin is generally positive on Puerto Rico. Larkin is Senior Vice President and Director of Credit Analysis at H.J. Sims. At the Bloomberg Muni Link conference last November, Larkin thought the interest rate that Puerto Rico would have to pay to sell a third lien of its Sales Use Tax bonds (known as SUT bonds or Cofina 3.0) would be around 7 percent. This was pretty much in line with market chatter.
— Cate Long (@cate_long) January 6, 2014
Since November though, market sentiment about Puerto Rico’s debt has taken a nosedive. What Larkin then called “hysteria” could now be called panic. A second lien Cofina (2.0) traded in institutional size on Monday at 8.35 percent (see tweet above). A second lien bond has a higher claim on tax revenues and is better quality than a 3rd lien Cofina. A third lien Cofina (3.0) would have come to the market above 8.35 percent because its seniority in the capital structure is lower.
The three major raters have first lien Cofinas at A2, AA-, AA- and second lien Cofinas at A3, A+, A+. Most market participants believe that a Cofina 3.0 bond offering would be rated a high BBB, the lowest investment grade.
Here is S&P on Cofina (SUT) bonds in an October 2013 report (Page 3):
Despite what we view as weak economic trends, SUT collections have risen every year except one since the tax began to be collected in fiscal 2007. In fiscal 2009, there was a 5 percent drop. Since then, SUT has increased 0.6 percent in fiscal 2010, 1.2 percent in 2011, 2.8 percent in 2012, and 3.3 percent in fiscal 2013, to $1.175 billion.
It is true that SUT (Cofina) collections have increased slightly year to year, but payments to bondholders are legally required to increase 4 percent every year. Collections have not kept up with increased payments to bondholders, which means less revenue to the general fund. More importantly, the Puerto Rico legislature expanded the tax collection base for fiscal year 2014 that began last July, but tax collections have not gone up as much; certainly not by a double digit increase. From S&P again:
Puerto Rico has enacted an expansion of the SUT base to business services that it expects will substantially increase pledged revenues in fiscal 2014. The commonwealth has budgeted an increase of 28.7 percent in SUT in fiscal 2014, which includes a 2.5 percent increase due to underlying economic activity on the existing tax base. At this point, the exact magnitude of the increase due to the expansion of the base is unknown.
Fitch said in a November report that SUT/Cofina revenues need to continue expanding:
Rating stability is sensitive to evidence of continued growth in the pledged sales tax so that coverage of increasing debt service requirements remains satisfactory. Failure to realize materially increased revenues from the recent base expansion and/or weakness in the economy that translates to reduced sales tax revenue expectations and lower projected coverage would lead to downward pressure on the rating.
Puerto Rico has announced it intends to sell a Cofina 3.0 bond in January or February. The most important question is whether there is sufficient new Cofina tax collections to support it. Will Puerto Rico be willing to pay market rates above 8.5 percent to sell Cofina 3.0? Stay tuned.