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The Puerto Rican Default Doesn’t Impact You? Think Again.

No U.S. state or territory has defaulted on its general obligation bonds since the Great Depression. Just think of the turmoil since then: military conflicts, economic upheavals, natural disasters and political crises. 

But Puerto Rico’s bond default in the summer of 2016 reminds us once again that there is no such thing as a risk-free investment—general obligation bonds included. These types of bonds are not repaid by a dedicated revenue stream, but by the full faith and credit of the issuing governmental agency. As such, these defaults are exceedingly rare. 

Troubling Numbers

It has been more of a marathon toward default for Puerto Rico, rather than a sprint. So the outcome should not come as a complete surprise. (Actually, the bond markets already factored a possible default into pricing, so the overall bond market has not been hit too heavily.)

A closer look at some important economic indicators for Puerto Rico reveals that it has only paid about half of the $2 billion that was due June 30, and the island is still in debt to the tune of $70 billion. Manufacturing has lost a significant number of jobs due to expiring tax credits, and unemployment hovers between 12% and 14%. 

PROMESA

The U.S. federal government has jumped into the fray by passing the Puerto Rico Oversight, Management, and Economic Stability Act (“PROMESA”). While the bill does not provide direct financial relief, it does establish a fiscal control board to oversee any budget created by the island’s government. Should a proposed budget not be balanced, the board has the power to implement various economic measures. PROMESA also protects Puerto Rico against creditor litigation during the restructuring.

Bond Market Impact

Suspending payments of general obligation and certain other bonds helped restore market stability and enabled bond prices to rebound from historic lows. However, Puerto Rico’s economy continues to contract, and it cannot access the markets to continue to issue bonds to cover its budget shortfalls. 

It remains to be seen how much of coming debt maturities will be impacted or how much will ultimately be paid. The island’s constitution guarantees repayment before all other financial obligations, including salaries and payments for essential government services. The goal for PROMESA is to create a more orderly budget reform process as well as help broker a repayment compromise between the island and bondholders.

Your Stake in This

Millions of Americans are invested in muni-bond funds from Oppenheimer, Goldman Sachs, Franklin Templeton and others. These funds are some of the largest holders of Puerto Rico’s debt. 

According to Morningstar Analyst Beth Foos: “…(H)alf of U.S. open-ended municipal-bond funds hold some exposure to debt of the commonwealth …. (F)unds collectively own more than $11.4 billion of the islands debt or just over 15% of its outstanding issuance.” So, essentially, just about everyone with a 401(k) or other retirement vehicle is invested in Puerto Rico.

Dos and Don'ts

While investments in distressed debt can be extremely risky, the key is to not panic. There are steps you can take to mitigate certain bond-market risks: (1) examine the underlying financial fundamentals of the issuing agency; (2) don’t put to many financial eggs in one basket; and (3) seek insured bonds.

Conclusion

Puerto Rican bonds should not be a total loss, as there will eventually be some level of repayment, and insurance or reserve funds might cover some losses. There may also be smaller short-term payments in exchange for higher payments over the long term. Puerto Rico had previously proposed to offer general obligation bondholders 83.5% of what they are due. So even though this may be a once-in-a-lifetime economic event, investors are still well-positioned in the municipal bond market.

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