Puerto Rico defaults on $422 mn debt payment: Here is how the island got into this mess

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New Delhi | Published: May 3, 2016 11:36:16 AM

Puerto Rico faces a staggering 45-percent poverty rate and a shrinking population as it enters the most dire stretch of its fiscal crisis.

Puerto RicoAs a US territory, Puerto Rico cannot file for bankruptcy protection. It has been pleading for Washington to offer it a lifeline. (Reuters)

Puerto Rico’s government on Monday declared that it will skip making a $422 million bond payment. This default is by far the largest by Puerto Rico, who has been struggling under the weight of $72 billion in debt that its officials say it cannot pay.

Puerto Rico faces a staggering 45-percent poverty rate and a shrinking population as it enters the most dire stretch of its fiscal crisis. It owes another $1.9 billion on July 1 that Governor Alejandro Garcia Padilla says it cannot pay.

The Government Development Bank (GDB) default is the most significant yet in Puerto Rico, because the bank acts as the main depositary and liquidity source for public agencies like the island’s highway and infrastructure authorities.

Both the government and the creditors, who call themselves the Ad Hoc Group and hold roughly $935 million of the GDB’s nearly $4 billion in bonds, said they would continue negotiations for another 30 days. The Ad Hoc Group includes hedge funds Avenue Capital Management, Brigade Capital Management, Claren Road Asset Management, Fir Tree Partners, Fore Research & Management and Solus Alternative Asset Management.

Here’s a breakdown of what has happened to Puerto Rico:

How did Puerto Rico get into this mess?

Puerto Rico has been in an economic recession for roughly 10 years, caused by several factors. Manufacturing jobs started leaving the territory after certain tax credits expired, and the global economic downturn that started in 2007 compounded the impacts. The territory’s unemployment rate is 12.2 percent, more than double the 5 percent unemployment rate for the U.S. Residents have been leaving the territory in search of new opportunities.

Puerto Rico’s government borrowed heavily to cover budget shortfalls. Its debt levels have become so large that the government is unable to pay its debts and provide basic government services. Roughly a third of Puerto Rican tax revenue now goes to cover its debt.

Why would investors lend so much money?

Puerto Rico’s bonds are exempt from federal or state income tax to residents of all 50 states. That made its bonds attractive to investors across the U.S.

Watch: Puerto Rico’s debt crisis – How it happened

Why can’t Puerto Rico go into bankruptcy like detroit?

Since Puerto Rico is not a state, it is unable to access what’s known as Chapter 9 of the U.S. Bankruptcy Code. There are current bi-partisan discussions to change this in Congress, but the bill is currently stalled in committee.

The White House has put forward a plan that would allow Puerto Rico’s government to restructure its debt and impose new oversight on finances, among other measures.

Why does this default matter more than previous ones?

Because Puerto Rico is now heading toward defaulting on bonds that were sold to investors as especially safe.

The debt that Puerto Rico defaulted on earlier this year, roughly $37 million in bonds issued under the Puerto Rico Infrastructure Financing Authority, were considered low priority bonds by the government and not backed by the constitution. The bonds that Puerto Rico defaulted on Monday are considered middle priority bonds, issued by a struggling entity known as the Government Development Bank.

Some of these bonds coming due July 1 are what’s known as general obligation bonds, issued directly by Puerto Rico’s government and are constitutionally protected.

A default of general obligation bonds would be considered a far more serious default by investors, according to Mark Taylor, a portfolio manager at Alpine Funds. His firm has $3.5 billion in assets under management and it owns some Puerto Rican debt, but that debt is protected by insurance.

And why would that be bad?

Without the ability to go into bankruptcy, the only avenue investors will have to resolve their differences would be through the courts, a process that could take years. A group of investors, mainly hedge funds, have bought distressed Puerto Rican debt betting that they can get higher payouts through regular courts than through U.S. Bankruptcy courts.

Remaining in legal and financial limbo would likely push the island’s economy into even steeper economic turmoil. The courts could also rule that Puerto Rico is legally obligated to pay all its bonds, forcing the government to cut basic services.

What is US Congress doing to help?

A House bill would create a control board to help manage the island’s debt and to oversee some court-ordered debt restructuring. But the legislation has not yet come up for a vote as some conservatives and Democrats have objected to the approach.

House Speaker Paul Ryan has pushed the bill, saying the U.S. may eventually have to bail out the territory if Congress doesn’t act soon.

Congress left on recess with both the House and the Senate stalled on the issue. On Monday Treasury Secretary Jacob Lew wrote a letter to Congress urging action. Without a plan to restructure the debt, Lew wrote, “bondholders will experience a lengthy, disorderly, and chaotic unwinding, with non-payment for many a real possibility. The people of Puerto Rico will be forced to endure additional suffering.”

Is investors portfolio at risk?

Most broad municipal bond mutual funds have already sold their Puerto Rican debt, and it’s now mostly owned by hedge funds. Individuals who own Puerto Rican bonds are suffering, though, and funds that target distressed, especially risky bonds in hopes of earning high yields may also take losses.

The fund company Oppenheimer has exposure to Puerto Rican debt through its Rochester line of funds and Franklin Templeton has exposure through its Franklin Double Tax-Free Income Fund. Investors who own those mutual funds or individual bonds should talk with a wealth adviser.

Importantly, several Puerto Rican bonds are insured. If Puerto Rico does default on a particular bond that is insured, the bond insurance companies would be obligated to cover the principal and interest.

In general, municipal bond funds, which aim to deliver modest but steady returns, have not been rattled by the Puerto Rican defaults and experts do not expect future fallout. The largest municipal bond fund has returned 2 percent so far this year, including dividends, and 4.6 percent over the past 12 months, according to FactSet.

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