By Martin Hutchinson, Global Markets Analyst
For the past few weeks, Greece’s flirtation with default has dominated the headlines – and for good reason. The danger to international markets is very real.
But for American income investors, a default closer to home could prove even more disastrous.
Should Puerto Rico default on $72-billion worth of municipal bond debt, it would hit U.S. income investors twice over. First, it would impact their holdings of the island’s debt. Second, it would rattle other shaky municipal bond issuers.
On June 29, Puerto Rico’s Governor, Alejandro Garcia Padilla, proposed that the country’s creditors postpone interest payments “in order to invest in Puerto Rico.”
Free Reports:
Get Our Free Metatrader 4 Indicators - Put Our Free MetaTrader 4 Custom Indicators on your charts when you join our Weekly Newsletter
Get our Weekly Commitment of Traders Reports - See where the biggest traders (Hedge Funds and Commercial Hedgers) are positioned in the futures markets on a weekly basis.
This caused bond prices to go into a tailspin – especially the $3.5-billion worth of 8% bonds due in 2035 that were issued just last year. After making scheduled payments on July 1, Puerto Rico is now in discussions with creditors under a forbearance pact that lasts until September 15.
Beyond that date, default seems more or less inevitable.
Yet unlike Greece, Puerto Rico didn’t get into its current mess through spectacularly bad government. In fact, the island benefited for many years from an IRS provision titled “Section 936.” Under the provision, companies based in Puerto Rico were exempt from U.S. tax on their Puerto Rican income. However, Section 936 was terminated in 2006 – and the island has been in recession ever since.
Padilla’s predecessor, Governor Luis Fortuño, even instituted spending cuts and tax increases, but people and businesses still emigrated in large numbers. That decimated Puerto Rico’s tax base, and at this point, the sums simply don’t add up.
Now, because Puerto Rico is a U.S territory, its debt is equivalent to U.S. municipal bonds. That means income from the bonds is free from federal income tax, which explains why Puerto Rican bonds are held by many income investors. However, that also means that Puerto Rico’s $72-billion default would fall almost entirely on individual investors in the United States.
Plus, since Puerto Rico can’t technically go bankrupt, debt restructuring would be undertaken without the protection of U.S. bankruptcy law. That means obligations such as union contracts and pensions would be tough to ignore. Should a debt restructuring take place, analysts project that Puerto Rico’s bondholders may receive as little as 35% of their obligations in present value terms.
Indeed, Detroit’s recent bankruptcy showed how damaging municipal bankruptcy proceedings can be for bond investors. The final settlement paid different classes of creditors vastly different sums. General obligation bonds recovered about 70% of their value, but other creditors were forced to settle for a third or less. Plus, while bankruptcy had theoretically extinguished pension and wage contracts, the 10% “haircut” to Detroit’s pensioners ultimately gave them a far better deal than bondholders.
The Ripple Effect
Puerto Rico’s fiscal problems have implications for other troubled municipalities, as well, including Chicago, the state of Illinois, and parts of California.
All feature a deadly combination of overspending local governments and a lack of exceptional attractions to keep footloose, high-earning inhabitants in place. On the other hand, some overspending places – such as San Francisco, Washington, D.C., and New York – have such vast employment opportunities or unique attractions that they become “sticky” and can thus afford (up to a point) to harass their inhabitants with excessive taxes.
For its part, Illinois probably has the highest risk of following Puerto Rico into insolvency. You see, in addition to overspending, Illinois has funded just 43.4% of its pensions – and the unfunded liability is now more than $80 billion. To top it off, the state budget is bedeviled by controversy, with the Democrat legislature attempting to force the Republican governor to raise taxes without cutting spending.
Bottom line: Puerto Rico’s default would hurt income investors, weaken the municipal bond market, and increase the likelihood of other bankruptcies. Since the great majority of municipal bonds are owned directly or indirectly by U.S. individual income investors, they should be paying much more attention to Puerto Rico than to Greece these days.
Good investing,
Martin Hutchinson
The post Why Puerto Rico Could Cost You More Than Greece appeared first on Wall Street Daily.
