Puerto Rico is about to default: What’s next for bond investors

2015-08-02

Puerto Rico’s first missed debt payment is only the tip of the iceberg of a severe economic crisis.

By

EllieIsmailidou

Markets reporter

Puerto Rico will likely default on its bonds for the first time ever on Saturday, a move that potentially could unleash a domino effect on other Puerto Rican debt, threatening U.S. investors with yet more losses.

“The signal from breaking a seven-decade streak of bond payments may imply more defaults are looming,” Daniel Hanson, an analyst at Height Securities, said in a note.

A default could hit investors widely, as approximately 30% of all U.S. muni mutual funds have holdings in Puerto Rico, a U.S. territory. Bond prices for Puerto Rico’s debt already have plunged this year, hurting performance.

The island has been at the brink of missing a payment on its $72 billion in bonds in the past but until now has always managed to secure a last-minute financing deal. The most recent lifeline came from bond insurers of the island’s power utility in early July.

But on July 15, the commonwealth took the unusual step of announcing that it had failed to make a $94 million deposit for the debt of its Public Finance Corporation (PFC), which was seen as a signal that the deadline for payment on Saturday would be missed and the commonwealth would default. A few days later, Standard & Poor’s Ratings Services lowered its credit rating on debt issued by PFC in 2011 and 2012 and called a default on those bonds “a virtual certainty.”

However, because this latest deadline falls on a weekend, payment can also be made Monday, a spokeswoman for Puerto Rico told The Wall Street Journal.

Investors are also worried about other types of bonds that face a repayment deadline on Saturday, most notably those issued by the island’s Government Development Bank (GDB).

“The market is anticipating default on GDB bonds,” said Height’s Hanson.

But he said he doesn’t expect a default because of differences in the bond covenants that make a default more complex than for PFC. “GDB is not yet prepared for the legal fight...associated with missing a bond payment,” he said.

The worries about these bonds have dragged down prices of other Puerto Rico bonds. The S&P Municipal Bond Puerto Rico Index has dropped 10.8% year-to-date and its total market value has lost $6.9 billion.

But not all Puerto Rican bonds are created equal, being backed by different types of revenues, such as tax revenues, road tolls and electricity bills.

The first thing investors should do is “find out what revenue backs their bonds and whether their bonds are insured or not,” said Mary Talbutt, head of fixed income at Bryn Mawr Trust.

Approximately 30% of muni mutual funds have holdings in Puerto Rico, more than half of which are insured, according to a Charles Schwab Investment Management report. As for the revenue that backs the bonds, most exposure is with the sales-tax backed bonds, known as COFINA bonds from their Spanish-language acronym, and the general-obligation bonds, known as G.O. bonds, according to the report.

In that sense, investors that hold the PFC bonds are somewhat in a bind because “the language in PFC bonds makes payment dependent on appropriations from Puerto Rico’s legislature,” Hanson said.

This is the main difference between the PFC bonds and the G.O. bonds. The former require appropriation, while the latter are backed by the full faith and credit of the territory and their repayment is guaranteed by the constitution.

“The language... makes [the PFC bonds] a weaker credit relative to G.O. bonds. But a default is still a default,” said Andrew Gadlin, a research analyst at Odeon Capital Group.

Meanwhile, a bill has been introduced in the U.S. Senate that would allow Puerto Rico’s public corporations and municipalities to seek Chapter 9 bankruptcy protection.

“Broad support for the bill has been lacking... We suspect interest in advancing such a bill will increase as Puerto Rico’s fiscal situation becomes more dire,” said Alan Schankel, director of municipal bond strategy and research at Janney in a note.

A debt service payment default could illustrate how “dire” the situation is, perhaps pushing U.S. Congress to make a decision sooner than later.

But for the time being, investors that hold the PFC bonds can petition the Puerto Rico’s Government Development Bank to make them whole, Hanson said. “As per the bond covenants, the GDB is required to respond ‘in a timely manner’ or bondholders may bring a suit in San Juan court,” he added.

Meanwhile, the Puerto Rico’s top officials signaled they are moving toward “consensual adjustment” of part of the island’s debt during a meeting with creditors at Citibank’s offices in New York on July 13.

It remains to be seen whether this would only involve an extension of debt-repayment deadlines or would go as far as implementing some type of haircut.