For investors, Puerto Rico's debt crisis casts a cautionary spotlight on bonds issued by distressed governments.
Long hailed for their "triple-tax-free" status — exempt from federal, state and local income taxes — Puerto Rico bonds have fallen out of favor with investors amid the island's economic crisis.
After Puerto Rico Gov. Alejandro Garcia Padilla said Monday that the commonwealth's $72 billion in bond debt is "unpayable," concerns about a default escalated.
Puerto Rico celebrated a small win two days later when bondholders reached a deal to avoid a default on a $415 million debt payment, but it's only a temporary reprieve. Investors and the island must come to an agreement on the electric-utility Prepa's debt restructuring by September.
For now, investments in Puerto Rico debt are safe. But if the island opts to conserve cash and stop paying debts, watch for a firestorm of lawsuits.
It's a risky game to jump in now. Matt Fabian, managing director of Municipal Market Advisors, said Puerto Rico debt investors have been limited mostly to sophisticated hedge funds in recent years. And hedge funds are quick to sue governments that default on debt payments. One case in point: Hedge funds have sued Argentina over it in 2001.
Garcia Padilla has called for Congress to let the island's governmental entities file for municipal bankruptcy, which is currently available only to local governmental units in the 50 states.
Congress has yet to act, but if it changes the law to give Puerto Rico access to Chapter 9, bonds could be at risk. Insured bonds give bondholders some measure of safety because in the event of a default the insurers have agreed to make up the difference.
However, most Puerto Rico bonds are uninsured, experts say, potentially exposing bondholders to significant cuts in interest payments in the event of a bankruptcy.
"Either they have to put major austerity onto a deeply economically distressed population, raise taxes — which is only going to collapse the economy further — or cut their debt," Fabian said. "So, really, the only choice possible is for deep cuts across their entire debt structure."
Even without bankruptcy, experts say it's extremely unlikely that Puerto Rico can meet its obligations without reducing its overall debt load.
More than 52% of U.S. municipal bond funds have exposure to Puerto Rico, according to Morningstar. If the island's debt crisis descends further, those funds that have a large exposure to PR bonds could take a hit in the marketplace. However, many funds are diversified, limiting exposure to the bonds, and may not take much a hit.
Investors concerned about the impact of Puerto Rico on their portfolios should consult with a certified investment adviser to assess their individual situation.