Puerto Rico failed to pay around $779 million worth of bond payments due on July 1, which marked its first ever default on constitutionally guaranteed debt. The historic decision by Gov. Alejandro Garcia Padilla to forego the payments could result in up to $358 million in losses for bond insurers that must cover the missed payment. But bond prices and yields were relatively unchanged since the default was widely expected and already priced in.
In this article, we will take a look at what the default means for Puerto Rican bondholders and the wider municipal bond market.
Restructuring the Debt
Puerto Rican leaders failed to reach a voluntary agreement with creditors over the past few weeks. After the talks broke down, a group of hedge funds sued the commonwealth over its local debt-moratorium law that legally requires the island to pay creditors ahead of essential public services. Congress responded by quickly finishing its bipartisan bill that was expedited through the Senate amid concerns of a growing legal cloud over the issue.
On July 1, Puerto Rico signed the new restructuring legislation that will create a fiscal control board and a framework to address its debt problems. Under the terms of the legislation, the newly created board will be responsible for reigniting economic growth and restructuring the commonwealth’s debt to enable that growth. The legislation also prevented creditors from forcing bond payments ahead of essential services using the court system.
Uninsured bonds were trading at roughly 67.5 cents on the dollar following the default – roughly equal to their pre-default levels – while insured bonds were trading near 100 cents on the dollar. These dynamics suggest that investors are relatively confident in an amicable agreement coming out of these restructuring efforts. However, the true results could take months or years to materialize as the commonwealth faces a number of headwinds.
Impact on the Market
Bond insurers have the greatest exposure to Puerto Rico’s default since they must cover the missed bond payments. According to Credit Sights, the largest insurance companies shouldn’t have a problem making timely interest and principal payments in the event of a full default, although FGIC announced earlier this year that it would only pay 22% of the $6.4 million in interest that it insured – hardly a vote of confidence among smaller insurers.
Financial institutions that hold large amounts of uninsured bonds could also take a hit from the restructuring. For instance, Oppenheimer Funds Inc. owned debt with a face value of $7 billion that included $6 billion in uninsured bonds. Franklin Templeton Inc. also holds about $2.7 billion in face-value bonds that are largely uninsured in its mutual funds. It’s unclear how these funds will be affected as income investors miss out on payments.
The good news is that Puerto Rico’s default appears to be an isolated event within the larger municipal bond market. In fact, muni bonds have continued to strengthen thanks to low Treasury yields and favorable monetary policy following the ‘Brexit’ vote. The island’s debt problems have been well known for some time and are largely unrelated to the larger U.S. mainland economy that continues to be relatively strong.
The Bottom Line
Puerto Rico’s default on $779 million worth of general obligation bonds on July 1 spurred the U.S. government into taking decisive action to address the issue. While bond insurers and financial institutions took a hit from the missed payments, most investors appear confident that the island commonwealth will be successful in restructuring the debt and returning to growth through a series of fiscal and financial reforms.
Investors in the larger municipal bond market have very little to worry about, since Puerto Rico’s problems appear to be mostly isolated. With Treasury yields moving lower and interest rates set to remain steady following the ‘Brexit’, the muni market continues to be an attractive asset class for most U.S. investors capable of realizing the tax benefits.