Puerto Rico is making headlines this morning with their decision to default on a $433 million payment due to its bondholders. Making matters worse, the island is also signaling that it is a near certainty that they will also default on a $2 billion payment in July.
These defaults are just the tip of the iceberg for Puerto Rico’s financial problems. Although a combined $2.4 billion in defaulted debt may sound like a lot over the span of a few months, this island actually owes over $70 billion that has been accumulated over the past several years. That’s a big number (only California and New York have a bigger debt load), and more defaults in the future could easily happen unless they find a way out of the mess that its leaders have created.
Puerto Rico debt is broadly owned in several mutual funds and other bond funds because of its attractive yield, thanks to a law that shields investors from paying taxes on income generated from these bonds. Hence, investors want to know just how much exposure they may have and downside risk they face.
Before panic takes over, here are three important facts regarding Puerto Rico that should alleviate some of the concern over the impact of this default:
- Defaults are Telegraphed: Although defaults catch headlines, as in the case with Detroit, they are actually known well in advance. Professional investors have expected for over two years that this day would come, and the institutions who own the majority of Puerto Rico debt have been building hedges in their portfolios for protection. Therefore, this is coming at no surprise to any professional investor who has exposure to its debt.
- Debt is Insured: Most mutual funds, bond funds, pension funds, and other large institutional investors typically own “investment grade” debt, which is rated by one of the major bond rating agencies (Moody’s, etc.). The only way Puerto Rico debt can receive this rating anymore is if it is insured against losses. Therefore, the only way most institutions can have material exposure to Puerto Rico debt is if they own the insured portion of its debt. The uninsured portion of Puerto Rico’s debt can only be owned by junk bond funds and “distressed debt” funds, and these investors are the ones who are at risk of any major losses.
- Insurers are Fine: Fears are circling around in media outlets that those companies who are on the hook to pay claims in the event that Puerto Rico defaults cannot cover all the losses are inaccurate. The debt insurers with the most exposure to Puerto Rico, specifically MBIA and Assured Guarantee Ltd., have all publicly stated that they are more than capable of paying claims, so this concern should be dismissed. Furthermore, the ratings agencies maintain AA- or better ratings on the companies who have insured this debt, which is a further sign of confidence that these insurance companies can withstand even the most dire outcome for the island.
This is not to say that Puerto Rico will be fine. The island cannot declare bankruptcy without approval from Congress, and the odds of this happening appear to be low. There is pushback from both Democrats and Republicans for different reasons. For example, permitting bankruptcy is akin to a government bailout, and many politicians don’t like the idea of forcing taxpayers in Texas, Florida, and other states to be on the hook.
In all honesty, the future does not look great for Puerto Rico without some major political reform. The island’s leaders put themselves in this situation, and the unfortunate outcome is that its citizens are now paying the price. The result of years of fiscal mismanagement has led to a 45% poverty rate and an exodus to the U.S., where roughly 1,500 citizens are leaving the island every day. Statistics like these are throwing gasoline on an open flame, as the tax base and ability to collect revenues for government services falls each time someone leaves.
I have no idea how all of these problems will get resolved, or if they ever will, but I am much more certain that the impact to those investors who own insured Puerto Rico are going to be fine as long as they don’t panic.