Analysis: Puerto Rico's new governor a question mark for bonds

Fri Nov 9, 2012 6:53am IST

Popular Democratic Party gubernatorial candidate Alejandro Garcia Padilla (L) celebrates his lead over Republican Governor Luis Fortuno in the gubernatorial election, which gives him the tendency to be proclaimed as the new governor, as he arrives at the party headquarters in San Juan November 7, 2012. REUTERS/Ana Martinez

Popular Democratic Party gubernatorial candidate Alejandro Garcia Padilla (L) celebrates his lead over Republican Governor Luis Fortuno in the gubernatorial election, which gives him the tendency to be proclaimed as the new governor, as he arrives at the party headquarters in San Juan November 7, 2012.

Credit: Reuters/Ana Martinez

(Reuters) - Big borrower Puerto Rico is worrying America's $3.7 trillion municipal bond market by voting in a new, unfamiliar governor and ousting a pro-business reformer whose painful economic initiatives seemed to be starting to bear fruit.

Governor-elect Alejandro Garcia Padilla this week narrowly beat Luis Fortuno, in office since 2009, after a campaign that turned in part on promises of job gains for a Caribbean island bedeviled by 13.6 percent unemployment and high violent crime.

The power shift casts into doubt the future of Fortuno's policies, such as privatizing toll roads and airports, promising Wall Street to ease pension-fund shortfalls, and knocking down annual budget deficits of $3.3 billion by 80 percent.

U.S. institutional investors, who hold much of Puerto Rico's $52 billion of high-yielding, tax-supported debt, often applauded Fortuno's reforms -- including 30,000 or more government layoffs and spending cuts -- as the best way to stimulate the island's economy and safeguard their bond investments.

"We know little about the intended financial policies of the incoming governor, and this uncertainty is a credit negative for bonds," debt analyst and Janney Capital Managing Director Alan Schankel said on Thursday.

Investor anxiety over the election has been clear for months in trading of Puerto Rico's triple tax-exempt debt, which portfolio managers of state-specific and other mutual funds favor for its high yield and geographic diversification.

Puerto Rico debt has sat out a months-old price rally in U.S. munis, and spreads between the island's 10-year debt and AAA-rated issues have widened since late July by nearly a third, or 62 basis points, to 270, according to Municipal Market Data.

"We are seeing it lower," MacKay Shields Senior Managing Director John Loffredo said on Wednesday, when the spread on Puerto Rico's 10-years widened 5 basis points. "You will be seeing a new budget and priorities. We will have to see what he does."

TIME IS RUNNING OUT

"The market's indicating that time is running out for Puerto Rico to remedy itself," said Dan Heckman, senior vice president at U.S. Bank Wealth Management.

Now a senator in Puerto Rico's island legislature from the Popular Democratic Party, Garcia Padilla said in an interview published on Thursday in the El Nuevo Dia newspaper that his policies would center on jobs creation.

"We will take care of the debt through a reduction in spending and an increase in wealth," Garcia Padilla said. "Resources will go to create jobs, and that's how the economy will grow."

Puerto Rico's $63 billion economy fell into recession well before the mainland United States did in late 2007 and is only now showing tentative signs of expansion, such as rises in local payrolls and electricity sales. Sales tax collections have also improved.

Garcia Padilla pledged to create 50,000 jobs in his first 18 months during his campaign, whose theme was "the people first" and included attacks on Fortuno for double-digit percentage jobless rates in place since at least 2000 and high crime.

The governor-elect also said he wants tax breaks and incentives such as wage subsidies to encourage hiring by small businesses and entrepreneurs.

"Mr Padilla's plans to maintain a course to reach structurally balanced budgets are unclear," Richard Larkin, senior vice president at Herbert J Sims & Co Inc, said in a commentary. "A return to (the pre-Fortuno) administrations' borrow-and-spend philosophies would jeopardize Puerto Rico's bond ratings and threaten market access."

Bond holders and credit ratings agency analysts, including the ones at Moody's Investor Service who last July downgraded $16 billion of Puerto Rico sales-tax debt, see the island's $24 billion shortfall in its government-workers pension systems and wobbly economy as unavoidable for whomever is in power.

"Puerto Rico has huge fiscal challenges. Frankly, it doesn't matter who's elected; they will be faced with those challenges," said Heckman. "They need to just not walk in the right direction. They need to start running in the right direction."

(Reporting by Michael Connor in Miami; additional reporting by Reuters in San Juan; editing by Tiziana Barghini and David Gregorio)

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