UPDATE 2-Puerto Rico rating cut to junk status by S&P

Tue Feb 4, 2014 5:55pm EST

By Michael Connor

NEW YORK Feb 4 (Reuters) - Standard & Poor's on Tuesday cut its credit rating on Puerto Rico, dropping the cash-strapped U.S. territory's debt to junk-bond status on concerns about its ability to access capital markets.

The move, which may be followed by downgrades by other U.S. credit agencies that have big roles in setting interest rates, comes after S&P last month placed Puerto Rico on notice it might lose its investment-grade ratings.

S&P now rates the commonwealth at "BB+," or one level below investment grade, a development that may oblige some institutional investors to dump holdings of Puerto Rico's high-yielding debt and avoid buying any of its bonds during an upcoming debt sale.

Some Puerto Rico municipal bond yields rose above 10 percent after the late-afternoon ratings cut. A general obligation refunding bond maturing in 2036 hit a yield of 10.16 percent after trading at 9.66 percent earlier in the day, though trading volume was extremely light.

"A lot of it was priced in," said Barry HoAire, portfolio manager at Bel Air Investments in Los Angeles. "But the big concern is what is this going to do to Puerto Rico with respect to margin calls and how does that strain their financial flexibility going forward."

S&P, which had previously rated Puerto Rico "BBB-", said the downgrade may cost the island some $940 million for penalties and other costs tied to variable rate demand obligations and other securities.

The demotion to junk bond territory will likely raise interest rates and other financial costs for Puerto Rico, which has been readying for a debt sale of as much as $2 billion. It will also likely fan anew the fears of municipal bond investors.

"People realize Puerto Rico is a one-off situation," said Gary Pollack, head of fixed-income trading at Deutsche Bank in New York. "While it has some problems common to other municipalities, its stature as an island economy with a below-average economic base and some fiscal hurdles make it somewhat unique."

Puerto Rico Gov. Alejandro Garcia Padilla reassured island residents in a news conference in San Juan that the island's government would function normally and that he would press ahead with economic development efforts.

"My administration is not responsible for this downgrade, but as a governor, I am responsible to lead (Puerto Rico) out of it," Garcia Padilla said.

Puerto Rico finance officials said they were confident the island had sufficient liquidity until June 30.

With some $70 billion of tax-free debt, Puerto Rico's economy has long soured and has for months been under threat of a ratings downgrade by all three U.S. credit ratings agencies.

Moody's and Fitch Ratings have not announced ratings decisions.

S&P said it worried that Puerto Rico, a Caribbean island with 3.62 million people, has limited ability to sell more debt in the United States' $3.7 trillion municipal bond market and faced possible cash shortages.

"We believe these liquidity constraints do not warrant an investment-grade rating," S&P said in a commentary.

S&P, which also cut its rating on the island's fiscal agent, the Government Development Bank, to BB, said that all of its revised Puerto Rico ratings remain on negative watch.

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