Puerto Rico is about to default: What’s next for bond investors

Puerto Rico will likely default on its bonds for the first time ever on Saturday, a move that potentially could unleash a domino effect on other Puerto Rican debt, threatening U.S. investors with yet more losses.

“The signal from breaking a seven-decade streak of bond payments may imply more defaults are looming,” Daniel Hanson, an analyst at Height Securities, said in a note.

A default could hit investors widely, as approximately 30% of all U.S. muni mutual funds have holdings in Puerto Rico, a U.S. territory. Bond prices for Puerto Rico’s debt already have plunged this year, hurting performance.

The island has been at the brink of missing a payment on its $72 billion in bonds in the past but until now has always managed to secure a last-minute financing deal. The most recent lifeline came from bond insurers of the island’s power utility in early July.

But on July 15, the commonwealth took the unusual step of announcing that it had failed to make a $94 million deposit for the debt of its Public Finance Corporation (PFC), which was seen as a signal that the deadline for payment on Saturday would be missed and the commonwealth would default. A few days later, Standard & Poor’s Ratings Services lowered its credit rating on debt issued by PFC in 2011 and 2012 and called a default on those bonds “a virtual certainty.”

However, because this latest deadline falls on a weekend, payment can also be made Monday, a spokeswoman for Puerto Rico told The Wall Street Journal.

Investors are also worried about other types of bonds that face a repayment deadline on Saturday, most notably those issued by the island’s Government Development Bank (GDB).

“The market is anticipating default on GDB bonds,” said Height’s Hanson.

But he said he doesn’t expect a default because of differences in the bond covenants that make a default more complex than for PFC. “GDB is not yet prepared for the legal fight…associated with missing a bond payment,” he said.

The worries about these bonds have dragged down prices of other Puerto Rico bonds. The S&P Municipal Bond Puerto Rico Index has dropped 10.8% year-to-date and its total market value has lost $6.9 billion.

But not all Puerto Rican bonds are created equal, being backed by different types of revenues, such as tax revenues, road tolls and electricity bills.

The first thing investors should do is “find out what revenue backs their bonds and whether their bonds are insured or not,” said Mary Talbutt, head of fixed income at Bryn Mawr Trust.

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