Puerto Rico's Debt Crisis: Much Ado About Not MuchLearn more about this firm
Per a reader's request, today we'll talk about the impact of the current debt crisis in Puerto Rico. Not only is this a major issue for the Puerto Ricans and their investors, but it also sheds light on how similar crises are likely to play out in the future.
You might want to pay attention to this movie, because you will be seeing it again over the next several years—probably more than once.
Just another bankruptcy . . .
To summarize the situation, the Puerto Rican government (along with associated entities such as the utility companies) has been borrowing money for decades, racking up a total debt beyond what current revenues can support. After several rounds of negotiations between the government and its creditors, a unilateral declaration was made that the government would suspend all payments. As you might imagine, this development has captured everyone’s attention.
Such a massive default—the total debt amount is around $72 billion—is almost unprecedented. Ditto for the government’s decision to stop payments. And yet, the markets aren’t panicking. Why?
First off, this has been a slow-motion train wreck, and everyone saw it coming. Second, there is no real systemic impact. Under current proposals, investors will take a haircut—a 26- to 28-percent loss on general obligation bonds, and a 43-percent loss on sales-tax bonds—but the island will continue to operate and to pay the remaining portion of its obligations. The loss to investors, of around $15 billion, is substantial but not systemically threatening.
Although this is big (and somewhat unusual, given Puerto Rico’s unique legal structure as a U.S. territory), it’s still just another bankruptcy and restructuring. The markets have seen it before and will likely see it again.
The interesting part about the Puerto Rico crisis is what it tells us about the future. Many U.S. municipalities and even states are in similar positions—or even worse. Bankruptcies may be too strong a word, but expect to see multiple restructurings over the next decade or two. Lessons learned today should be valuable to municipal bond investors then.
So, what can we take away?
- First, sovereign entities can go effectively bankrupt. Credit analysis (that is, can they pay?) is as essential in municipal bond investing as it is in corporate bonds.
- Second, unlike with corporate bonds, investors aren’t necessarily first in line. Pensioners, for example, have historically had their benefits preserved even as investors got hit. In San Bernardino’s bankruptcy, investors lost 60 percent of their money while retirement benefits remained intact, and that looks likely to be the case in Puerto Rico as well.
- Third, despite both of these factors, municipal bonds continue to attract investors with very strong pricing right now. The market is not broken and doesn’t look likely to break.
It boils down to this: Municipal bonds carry risk, just like any other investment, so be careful what you buy. That said, the asset class is solid enough that even a major default, like Puerto Rico’s, won’t take it down any more than, say, Enron took down the stock market.
In the end, the situation in Puerto Rico should turn out to be no more important than any other municipal and nonmunicipal restructurings. We can learn from this, but it’s not the end of the world.
Municipal bonds are federally tax-free but may be subject to state and local taxes, and interest income may be subject to federal alternative minimum tax (AMT). The purchase of bonds is subject to availability and market conditions. There is an inverse relationship between the price of bonds and the yield: when price goes up, yield goes down, and vice versa. Market risk is a consideration if sold or redeemed prior to maturity. Some bonds have call features that may affect income.
Brad McMillan is the chief investment officer at Commonwealth Financial Network, the nation’s largest privately held independent broker/dealer-RIA. He is the primary spokesperson for Commonwealth’s investment divisions. This post originally appeared on The Independent Market Observer, a daily blog authored by Brad McMillan.