Either Puerto Rico’s lenders are really unlucky, or the credit ratings agencies totally screwed up.
A little over a year ago, when Puerto Rico issued its latest round of debt, S&P gave the general obligations bonds a rating of BB+. That was slightly higher than the BB rating rivals Moody’s and Fitch assigned to the commonwealth’s debt. These days, those ratings, particularly the higher one from S&P, are looking like really bad calls.
Puerto Rico hasn’t officially defaulted yet. But on Monday, Governor Alejandro Garcia Padilla said the U.S. territory is unlikely to be able to pay back its debt either in full or on time. And already the ratings agencies are essentially admitting they screwed up. On Tuesday, S&P lowered its rating of Puerto Rico to CCC-, saying a default event in the next six months is likely. Fitch lowered its rating on Monday. Moody’s said its current rating, a Caa2, the equivalent of a CCC, already indicates that the likelihood of a default by Puerto Rico is strong.
But that’s not what the raters were saying a little over a year ago, on the eve of Puerto Rico’s $3.5 billion offering. Of course, BB+ is far from S&P’s best rating. But it’s not its worst, either. That would be D. Unofficially, BB+ is a junk bond rating, but it’s the highest grade for junk. In its ratings definitions, S&P says that BB borrowers have some issues, but are “less vulnerable to nonpayment than other speculative issues.”
And it’s not unheard of for a BB+ borrower to default. A recent study from S&P found an average of nearly 9% of all borrowers who were rated BB+ defaulted after five years. For governments, like Puerto Rico, it was more like 4%.
But a BB+ borrower should never default within a year of getting that rating. Among government borrowers, that’s happened just 0.3% of the time on average, over the past 19 years, according to S&P.
Worse, the market seemed to know that Puerto Rico was in more trouble than the ratings suggested. When Puerto Rico issued its bond last year, it almost immediately started trading at an interest rate of 8.3%. That was significantly higher than the 5.6% that corporate junk bonds were trading at, according to the Bloomberg USD High Yield Corporate Debt Index. And that includes many bonds that were rated much lower than BB+. Such bonds should have been trading at a higher yield because, at least according to the raters, they were riskier bets than Puerto Rico.
So what happened? S&P says that BB rated bonds are more exposed to outside factors like adverse business or economic conditions than other issuers. And Puerto Rico’s economy, where the unemployment rate is still over 12%, is in a rut. But these problems weren’t unforeseeable a year ago. And they aren’t any worse. The island’s unemployment rate was actually higher in March 2014, when Puerto Rico did its $3.5 billion bond offering.
An S&P spokesman said, “We began downgrading Puerto Rico’s credit rating in early 2013 (after signaling concerns and placing a Negative Outlook on the rating in 2012), and were the first to lower the Commonwealth’s rating to speculative grade, in February 2014. Since then, the commonwealth’s ability and willingness to pay back its debt on time and in full have deteriorated at an accelerated pace, which we have regularly communicated to the market with subsequent rating actions, bringing the rating to its current level of CCC- with a Negative Outlook.”
After the financial crisis, the ratings agencies were widely criticized for giving high marks to mortgage bonds made up of subprime borrowers who quickly defaulted on their loans. S&P paid a nearly $1.4 billion fine to settle charges that it inflated its ratings in order to get business and please Wall Street banks. Since then, S&P and its rivals say they have fixed their problems. They have instituted new rules and gotten tougher on ratings. But given what just happened in Puerto Rico, it’s hard to give the raters’ ratings any better grade than a D. Needs improvement.
Update: The story has been updated to include a statement from Standard & Poor’s.