Cofina Bonds, Highly Popular Muni, Likely To See Downgrade: Wells Fargo

The bonds, known by their Spanish acronym Cofina, were first issued in 2006 by the Puerto Rico Sales Tax Financing Corporation. Collateralized by sales tax receipts and given significant legal protections by the Commonwealth, Cofina bonds enjoy a lofty Aa2 rating from Moody's Investors Services.

That rating puts Cofina bonds five notches above most Puerto Rican general obligation bonds, which are viewed as just a few rungs above junk status because of the island's poor fiscal condition.

Holding Moody's third-highest score, Cofina bonds are a rarity in the world of muni instruments: A security that offers a high rating, tax-exemption from federal, state and local taxes, and a generous yield. Ten-year Cofina bonds issued last year yielded over 4 percent while most other municipal securities with comparable ratings offered returns just north of 2 percent. It is no surprise, then, that Cofina bonds comprise a significant share of the municipal bond market, $16 billion, or some 0.55 percent of the $2.9 trillion U.S. municipal bond market.

But that privileged position could be in trouble now. In April, Moody's put Cofina bonds on negative watch, a precursor to -- though not a guarantee of -- a downgrade.

A downgrade would mean the bonds would be worth less and affect the liquidity of the market they trade in, something that has individual Cofina investors on tenterhooks and Puerto Rican politicians angry -- at each other.

It sure looks like they will downgrade Cofina from the [negative ratings watch] write-up, said Patrick Early, chief municipal analyst for asset manager Wells Fargo Advisors.

The reason for Cofina's possible multi-notch downgrade stems from a change in the methodology Moody's uses to assess bonds, Early said.

Currently, Moody's strictly segregates the way it applies ratings to different bonds issued by government agencies, depending on the revenue source providing payment coverage to the obligations. This has allowed issuers to have one rating applied to general obligation bonds backed by general tax receipts, another rating for those covered through special-purpose taxes and yet another for instruments supported by payments to public utilities. That approach enabled Cofina bonds to be viewed as much more stable than, for example, a Puerto Rican general obligation bond.

But Moody's is in the process of altering that methodology in favor of an approach that would view all bonds issued by municipal governments through a more convergent lens. Under this scenario, Cofina bonds could be dragged down to the level of other, less desirable Puerto Rican municipal instruments.

A downgrade would also deliver a blow to Puerto Rican office holders. The current government financed Cofina's debt obligations by establishing a 7 percent sales tax and safeguarding bond payments with strong, constitutionally backed legal protections. Yet those actions might have been in vain if an adverse credit action raises borrowing costs for future issues, including an offering expected later this year to cover a $300 million-plus budget shortfall. A much larger amount of Puerto Rico's sales taxes would need to be earmarked for paying off Cofina and other debt obligations rather than for improving conditions on the island, or, alternately, painful austerity measures would have to be imposed.

Despite Moody's review, Puerto Rican officials say that the credit rating on Cofina bonds will likely not be affected.

I hope and believe that the downgrade will not take place, Juan Carlos Batlle, president of the Government Development Bank, which underwrites the island's bond issues, told newspaper El Nuevo Día last week, after the government held a series of meetings with bondholders.

Municipal bond credit ratings are a touchy issue in Puerto Rican politics. The government was downgraded in August to Baa1 from A3 because of persistent deficit financing, public pension fund shortfalls and a deteriorating economy. And in March, when Reuters' municipal bond reporter Cate Long wrote a blog entry called Puerto Rico Is America's Greece, flagging the Commonwealth's withering financial condition and the deteriorating prospects for its bonds, current governor Luis Fortuño quickly fought back. His re-election team tried to discredit Long by claiming she was an Occupy Wall Street activist who had been fired from Wall Street in 2008 and was now writing commissioned articles.

Now, opponents of the government are making Cofina a campaign issue in the gubernatorial election this November, arguing that the administration has been foolish in its use of funds generated by the bonds issues. A commonly cited bullet point: Of the $16 billion raised via Cofina financing through 2011, only $2 billion has been invested in economic development initiatives or capital improvements. The government used the rest to plug holes in the budget.

Puerto Rico state senator Eduardo Bhatia, a prominent opposition figure, brought up the possible Cofina downgrade in a Legislature floor speech saying that the bonds have done little to ease the island's devastated housing market, 15 percent unemployment, high business costs, waning exports and tourism industry collapse.

The Cofina bonds, to which Fortuño pledged all of the sales tax for the next 40 years, are about to be degraded by Moody's, Bhatia said.

In a New York skyscraper, thousands of miles away from the palm tree-landscaped State Capitol where Bhatia spoke, Moody's analysts will likely take those aspects of Puerto Rico's dismal financial condition into account -- much to the dismay of island officials.

If the downgrade happens, Early noted, it is likely to be as much a reflection of changing methodology as a vote of no-confidence in the Commonwealth's ability to pick itself up economically.

What Moody's has to wrestle with is this: When you look at the cash flow and you do a kind of simple, flat stress test and it falls short, how do you justify a rating like that? Early said.