Municipal Brief. Puerto Rico Credit & Market Update 19 August 2015

Transcription

1 Puerto Rico Credit & Market Update 19 August 2015 CIO WM Research Thomas McLoughlin, Co-Head CIO Fundamental Research Kristin Stephens, analyst The Puerto Rico Aqueduct and Sewer Authority (PRASA) plans to offer USD 750mn of senior lien revenue bonds this week. If the utility is able to complete the sale, the Commonwealth will have demonstrated its market access at the individual issuer level. If not, it will emphasize Puerto Rico's broader market access challenges and could lead to further erosion in its bond prices, in our view. The Government Development Bank (GDB) does not believe PRASA will need to restructure its debt. We are less confident in its insulation from the island's financial woes. PRASA's five year financial projections include numerous optimistic assumptions, in our view. Conway MacKenzie, Inc. prepared an updated liquidity analysis for FY16. It shows that the Commonwealth's primary operating account is likely to report a cash deficit of USD 152.9mn by December 2015 and USD 511.6mn by June La Fortaleza Chief of Staff Víctor Suárez Meléndez estimates the GDB's liquidity at USD 1bn, from USD 778mn at the end of May. The Chief of Staff indicates that there is now sufficient liquidity to finance government operations through November. The Puerto Rico Treasury announced that revenue for the month of July 2015 was USD 20mn higher than estimated. General fund net revenues of USD 626.5mn were flat to USD 624.2mn collected in July 2014 (+ USD 2.3mn). Fig. 1: Price trends, Puerto Rico GO 8.00% due 1 July 2035 Last price, in USD Aug-14 Oct-14 Dec-14 Feb-15 Apr-15 Jun-15 Aug-15 Note: Puerto Rico GO 8.00% 2035 were issued at USD on 11 March Source: MSRB trade data, Bloomberg, UBS CIO WMR, as of 19 August All eyes on PRASA The market is focused on a proposed USD 750mn bond offering by the Puerto Rico Aqueduct and Sewer Authority (PRASA or the "Authority") this week. The utility has been obliged to postpone the bond sale for almost a year; there is some uncertainty as to whether there will be sufficient appetite for the bonds among high yield investors. The proposed offering represents the first time a Puerto Rico issuer has gotten this far in an attempt to access the bond market since March This report has been prepared by UBS Financial Services Inc. (UBS FS). Please see important disclaimers and disclosures that begin on page 8.

2 According to the Government Development Bank (GDB), PRASA's decision to issue bonds while the Commonwealth develops its own debt restructuring plan reflects the utility's unique financial circumstances. If the utility is able to complete the sale, the Commonwealth will have demonstrated its market access at the individual issuer level. If not, it will emphasize Puerto Rico's broader market access challenges and could lead to further erosion in its bond prices, in our view. The offering comes on the heels of a default earlier this month on bonds issued by the Puerto Rico Public Finance Corporation (PFC) where debt service payments were subject to annual legislative appropriation. One of the defaulted PFC obligations had been issued to finance PRASA's North Coast Superaqueduct System. Investors are also awaiting the delivery of the Commonwealth's broader debt restructuring plan, which is expected at month-end. PRASA has been the sole provider of water and sewer services on the island for the past 70 years. Proceeds of the bond issue will finance a portion of its USD 1.45bn, five year capital improvement program through 30 June 2019, reimburse certain capital costs incurred over the past three fiscal years, and refinance outstanding credit facilities. The bonds are secured by a first lien on gross revenues of the water and wastewater enterprise. Fig. 2: Select credits and price trends of Puerto Rico municipal bonds Last price, in USD Aug-14 Sep-14 Oct-14 Nov-14 Dec-14 Jan-15 Feb-15 Mar-15 Apr-15 May-15 Jun-15 Jul-15 Aug-15 Sales Tax Financing Corporation subordinate lien Puerto Rico Electric Power Authority Puerto Rico General Obligation Sales Tax Financing Corporation senior lien Puerto Rico Aqueduct and Sewer Authority Source: MSRB trade data, Bloomberg, UBS CIO WMR, as of 19 August CIO WM Research 19 August

3 PRASA's finances improved after it imposed a substantial rate increase in July The utility's historical reluctance to increase user rates is self evident. Prior to 2013, PRASA had increased rates on only two occasions since 1986 (in 2005 and 2006). 1 The rate increase in 2013 generated more than USD 300mn in additional annual revenue which allowed the utility to become self-sufficient for the first time in FY14. Until then, it had relied on support from the Commonwealth and the GDB. Fitch Ratings has noted that the average rate increase exceeded 60% and was well above its threshold for affordability. 2 PRASA expects to remain self-sufficient in FY15 but is bracing for results that are weaker than budgeted expectations. Puerto Rico linkages PRASA confronts many challenges, all of which influence its deep non-investment grade credit ratings. The majority of these are a product of its exposure to the Commonwealth of Puerto Rico. PRASA's financial projections do not consider the impact across the island of the implementation of the Commonwealth's fiscal adjustment and economic recovery plan. Government accounts represent about 13% of PRASA's annual revenues, while the island's weak economy and declining population affect the utility's service base. PRASA's financial projections assume a 0.5% year-over-year reduction in total annual billings from declines in the number of customers and in the rate of water consumption, an amount the utility reports is equal to the compound annual reduction in the number of accounts from FYs The consulting engineer (CE) commissioned to review PRASA's financial projections believes that the utility's own estimates in this regard may be too optimistic. PRASA's financial projections also assume that it will experience a 96% collection rate over the next five years. While not out of line with the utility's reported average collection rate of 95% for the FY period, we consider it aggressive. The consulting engineer cautions that the uncollectible rate could increase given the uncertain economic and fiscal situation facing the island. The CE recommended a more conservative collection rate. The collection rate from governmental entities historically has been weaker than retail customers. In addition, Puerto Rico is in the midst of a major drought and it is unclear how the drought and related water rationing plan might affect collections going forward. Over 415,000 customers are subject to a water rationing plan as of 5 August On this basis, PRASA estimates that it will experience a monthly loss of USD 13mn. Time will tell if the drought and water rationing plan have a more pronounced impact on revenues, but the CE has already expressed concern over the utility's ability to maintain service revenues, billings and collections in a very challenging economic environment. "We note that the rating on PRASA's debt has the potential to be as much as three notches higher than the GO debt rating of the commonwealth and related ratings absent the current fiscal distress affecting the Commonwealth. We will continue to correlate PRASA's rating with the commonwealth's unless and until there is certainty that PRASA is financially independent of and politically and statutorily isolated from the commonwealth's fiscal crisis." "We will monitor events to follow to what extent, if any, the commonwealth views PRASA as a possible source of liquidity." S&P, 18 August 2015 For now, PRASA's financial projections assume further rate increases of 4.5% in both FY18 and FY19. The FY18 increase has already been approved by the utility's board. Moody's observes that PRASA's planned bond issues are expected to increase its senior bond debt CIO WM Research 19 August

4 service requirements by approximately 47%, on average, in coming years. 3 PRASA's consulting engineer believes that PRASA's forecasted ability to support a higher debt load is largely dependent on the ability to implement the projected rate adjustments. We believe there is considerable uncertainty regarding the water utility's willingness and ability to impose such charges in an environment where the population is declining and the economy remains mired in recession. While the utility currently enjoys the legal ability and unilateral authority to raise rates, we are inclined to believe that political considerations may make it more difficult to impose higher charges going forward. 4 Keep in mind that the Commonwealth retains some discretion to alter the utility's rate setting power, as it did with the Puerto Rico Electric Power Authority (PREPA) in An independent body now exercises oversight of the electric utility's rates. Another area of uncertainty pertains to the future outlook for Commonwealth tax collections. There is no history to assess how planned changes to the Commonwealth's tax system might impact collections. For example, the implementation of a 10.5% value added tax (as scheduled on 1 April 2016) could materially increase PRASA's costs of goods and services. Approximately 70% of the utility's expenses are currently exempt from the sales and use tax, according to the consulting engineer. Fig. 3: Credit ratings, Puerto Rico and certain public corporations Moody's S&P Fitch Commonwealth of Puerto Rico (GO) Caa3 (neg) CCC- (CW neg) CC (RWN) Government Development Bank Ca (neg) CC (neg) COFINA Senior Lien Caa3 (neg) CCC- (CW neg) CC (RWN) First Subordinate Lien Ca (neg) CCC- (CW neg) CC (RWN) Puerto Rico Electric Power Authority Caa3 (neg) CC (CW neg) CC (RWN) Puerto Rico Highways and Transportation Authority Highway Revenue Bonds Ca (neg) CCC- (CW neg) Senior Transportation Revenue Bonds Ca (neg) CCC- (CW neg) Subordinate Transportation Revenue Bonds Ca (neg) CCC- (CW neg) Puerto Rico Aqueduct and Sewer Authority Revenue Bonds Caa3 (neg) CCC- (CW neg) CC (RWN) Guaranteed Bonds Caa3 (neg) CCC- (CW neg) CC (RWN) Puerto Rico Public Buildings Authority Caa3 (neg) CCC- (CW neg) CC (RWN) Puerto Rico Employees Retirement System pension funding bonds Ca (neg) CCC- (CW neg) CC (RWN) Puerto Rico Public Finance Corporation (Commonwealth Appropriation Bonds) Ca (neg) D Puerto Rico Municipal Finance Agency Ca (neg) CCC- (CW neg) Puerto Rico Convention Center District Authority (Hotel Tax Bonds) Ca (neg) CCC- (CW neg) Puerto Rico Industrial Development Company Caa3 (neg) CCC- (CW neg) Puerto Rico Infrastructure Financing Authority Special Tax Revenue Bonds (Rum Tax) Ca (neg) CCC- (CW neg) Puerto Rico Ports Authority Project Ca (neg) CCC- (CW neg) University of Puerto Rico Revenue Bonds Ca (neg) CCC- (neg) AFICA - Plaza Universitaria Project Ca (neg) CCC- (neg) Note: Neg = negative outlook. CW neg = CreditWatch negative. RWN = Rating watch negative. Source: Moody's, S&P, Fitch, UBS CIO WMR, as of 19 August CIO WM Research 19 August

5 Meanwhile, spending on electricity represents about 25% of PRASA's overall costs. We readily concede that lower crude oil prices mitigate the risk of higher rates for now but the ability of PREPA to offer PRASA a preferential rate for electricity while restructuring its own debt may be problematic. PRASA's exposure to the deeply underfunded Puerto Rico Employees Retirement System constitutes another significant risk. Its share of the retirement system's net USD 30.1bn pension liability as of 30 June 2014 is estimated at USD 1.59bn. As the net assets of the pension plan near depletion, significant increases in the Commonwealth's (and in turn, PRASA's) contributions to the system will be necessary in order to pay the annual pension benefits of retired employees. PRASA's projections also assume that the proposed bond issue is successfully placed at an interest rate of no more than 10%. A different outcome would represent a setback for the utility's capital plan and its ability to secure affordable permanent financing for its USD 90mn line of credit with Banco Popular and USD 67mn line of credit with the GDB. So, continued market access at an affordable cost is an important consideration for PRASA going forward given its extensive capital needs. Unique challenges Aside from the concerns associated with the Commonwealth's liquidity crisis, PRASA confronts its own unique challenges. The Authority has been obliged to respond to numerous environmental and regulatory requirements. Each of these imposes a financial burden. PRASA's financial projections rely on its ability to modify existing consent decrees, and thereby spread the investment (and corresponding future borrowing required) over a longer timeframe to lessen the pace of needed rate adjustments. Water loss from theft, leakage and other factors has been another chronic problem. More than half the water produced (59% in 2014) is unaccounted for and does not generate revenue as a result. PRASA's consulting engineer has concluded that the utility's ability to continue to successfully implement its operational initiatives to reduce water loss is uncertain. The CE also found PRASA's forecast of certain operating expenses to be ambitious, citing that it reduced the year-overyear escalator for maintenance and repairs, chemicals, insurance and other expenses to 1%, from 3%, in its financial projections. Commonwealth liquidity update The preliminary official statement issued in connection with the PRASA bond issue also included an update on the Commonwealth's liquidity position for FY16. The analysis was prepared by Conway MacKenzie, Inc. (Conway). Conway's report is an update to its original analysis included in the Commonwealth's Quarterly Report dated 7 May Conway finds that the Commonwealth's cash balance in its Concentration Account, in which it deposits and disburses amounts related to CIO WM Research 19 August

6 all funds managed by the Treasury, will have a cash deficit of approximately USD 152.9mn in December 2015 and USD 511.6mn in June 2016 in the absence of additional corrective measures. Conway also projects that the account will be in a deficit position throughout most of FY16 on a book balance basis. The Commonwealth's cash position did exhibit some improvement in the wake of its execution of USD 400mn in intergovernmental tax and revenue anticipation notes (TRANs) and the suspension of monthly set-asides for the repayment of general obligation debt service. The TRANs were purchased by the Commonwealth's public corporations, primarily the state insurance fund. La Fortaleza Chief of Staff Víctor Suárez Meléndez indicated that liquidity at the GDB had improved to USD 1bn from USD 778mn at the end of May, the last time an official update was provided. According to Mr. Suárez, there is now sufficient cash flow for government operations through November barring further liquidity injections, but an additional USD mn is necessary to get through the balance of the fiscal year. In addition to USD 562.3mn of risks identified in the Treasury's own projections, Conway estimates additional quantified risks ranging from USD 100mn to over USD 1bn in the current fiscal year. Unquantified liquidity risks (i.e. those not included in this estimate) include possible spending in excess of appropriations, unfavorable economic factors, pensions, and litigation or extraordinary expenses associated with restructuring activities. Conclusion We expect the market's reception of PRASA's bond offering to be closely watched. In our view, the outlook for the utility is clouded by its exposure to the financial challenges facing the Commonwealth in addition to its own specific concerns. Although the Government Development Bank has expressed a view that it does not believe PRASA will need to restructure its debt, we feel it is premature to treat the water utility as a separate and distinct entity from the government itself at this time. Investors await the announcement of Puerto Rico's broader debt restructuring plan. It is unclear what the implications will be for bondholders, but caution is clearly warranted. The Commonwealth has already made a conscious decision to default on bonds issued by the Puerto Rico Public Finance Corporation, a move we have characterized as the first act in a much longer play, and one that places creditors on the defensive. The liquidity position of the central government and the Government Development Bank remain tenuous and recent improvement reflects certain liquidity preservation measures as opposed to organic growth. The Garcia administration is seeking concessions from creditors and has emphasized its primary obligation to provide for the health and safety of island residents. We expect a broad array of the island's bonded debt to be targeted for restructuring. We expect that process to be complex, highly litigious, and if only indirectly have ramifi- CIO WM Research 19 August

7 cations for credits on the island like PRASA which have demonstrated some ability to be self-supportive despite the inherent volatility at hand. End notes 1 Puerto Rico Aqueduct and Sewer Authority, Preliminary Official Statement dated 10 August 2015, page 37 2 Fitch, "Fitch rates Puerto Rico Aqueduct & Sewer Authority's 2015A Senior Revs 'CC'; Maintains Negative Watch," 17 August Moody's, "Moody's assigns Caa3 to Puerto Rico Aqueduct & Sewer's $750M issue; outlook negative," 14 August 4 Beginning in FY18, PRASA can raise rates of up to 4.5% per year to a cumulative total of 25% without a public hearing process. CIO WM Research 19 August

8 Appendix Statement of Risk Municipal bonds - Although historical default rates are very low, all municipal bonds carry credit risk, with the degree of risk largely following the particular bond s sector. Additionally, all municipal bonds feature valuation, return, and liquidity risk. Valuation tends to follow internal and external factors, including the level of interest rates, bond ratings, supply factors, and media reporting. These can be difficult or impossible to project accurately. Also, most municipal bonds are callable and/or subject to earlier than expected redemption, which can reduce an investor s total return. Because of the large number of municipal issuers and credit structures, not all bonds can be easily or quickly sold on the open market. Terms and Abbreviations Term / Abbreviation Description / Definition Term / Abbreviation Description / Definition GO General Obligation Bond TEY Taxable Equivalent Yield (tax free yield divided by 100 minus the marginal tax rate) MMD Municipal Market Data Rating Agencies Credit Ratings I n v e st m en t G ra d e N on Ī n ve s t m en t G ra A1 A2 A3 Baa1 Baa2 Baa3 Ba1 Ba2 Ba3 B1 B2 B3 Caa1 Caa2 Caa3 Ca S&P Moody's Fitch/IBCA Definition AAA Aaa AAA Issuers have exceptionally strong credit quality. AAA is the best credit quality. AA+ AA AA- Aa1 Aa2 Aa3 AA+ AA AA- Issuers have very strong credit quality. A+ A A- BBB+ BBB BBB- BB+ BB BB- B+ B B- CCC+ CCC CCC- CC C A+ A A- BBB+ BBB BBB- BB+ BB BB- B+ B B- CCC+ CCC CCC- CC+ CC CC- Issuers have high credit quality. Issuers have adequate credit quality. This is the lowest Investment Grade category. Issuers have weak credit quality. This is the highest Speculative Grade category. Issuers have very weak credit quality. Issuers have extremely weak credit quality. Issuers have very high risk of default. d e D C DDD Obligor failed to make payment on one or more of its financial commitments. this is the lowest quality of the Speculative Grade category. CIO WM Research 19 August

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