Puerto Rico is an extremely popular, sunny vacation destination, especially in the winter. With that in mind, it’s hard to fathom how the U.S. island territory of 3.5 million people racked up $70 billion in public debt causing Puerto Rican bonds to trade at 20-50 cents on the dollar. On Monday, Puerto Rico defaulted on its $370 million debt payment, for the third time, paying the interest due on bonds issued by the Government Development Bank but nothing on the principal. Previous defaults include $143 million worth of appropriation bonds from Puerto Rico’s Public Finance Corp., and rum-tax securities issued by the territory’s Infrastructure Financing Authority. No one seems optimistic that Puerto Rico will come up with money for their July 1 payment of $1.9 billion either.
The story is a familiar one. Years ago there was strong investor demand for Puerto Rican bonds because they’re exempt from federal and state income tax in all 50 states. The territory met the demand by issuing debt by 18 different public debt issuers. In recent years, interest rates on these bonds crept higher as it became clearer that the territory would not be able to meet its obligations. Increased interest rates made the bonds attractive to mutual funds that wanted to offer high yields to investors who didn’t understand the default risks.
Would a broader Puerto Rican default affect your Kendall Capital portfolio or the municipal bond market generally? Probably not. Most of the bonds have been repurchased for pennies on the dollar by opportunistic speculators, mostly hedge funds, some of whom recently traded $900 million of face amount Puerto Rican bonds for 47 cents on the dollar. A similar agreement retired $33 million in debt held by a group of credit unions. The territorial government has proposed that holders of its general obligation bonds accept 74 cents on the dollar, and Congress is discussing the possibility of allowing the territory to file for bankruptcy under Chapter 9, currently an option for U.S. states but not Puerto Rico.
However, investors in some of the aforementioned mutual funds could be greatly impacted. Most municipal bond funds were reluctant to touch Puerto Rican paper with the proverbial ten-foot pole, knowing that the risk of default made positive returns problematic. But load fund company Oppenheimer loaded up on Puerto Rican debt through its Rochester line of funds, and the Franklin Double Tax-Free Income Fund holds the endangered paper as well. Both companies are now lobbying hard against any deal, but the most likely outcome is that they will become poster children for the dangers of recklessly chasing yields, particularly as the handwriting has been on the wall for years.