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Puerto Rico Default Could Hurt Municipal Bonds for the Long Run

Puerto Rico must create a comprehensive debt restructuring to avoid impacting the broader world of municipal bonds

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Puerto Rico is crumbling under a recession and $70 billion in debt, some of which the Commonwealth defaulted on last year. While this may seem like a small and distant problem, the truth is that it puts the entire municipal bond market one domino closer to collapse.

Puerto Rico Default Could Hurt Municipal Bonds for the Long Run
Source: Shutterstock

What should happen is what normally happens in a default: All the creditors should sit down together and work out a comprehensive restructuring that doesn’t screw anyone over.

Instead, the parties involved have abandoned their responsibility, and leave millions of fixed income investors with increased risk in their municipal bonds.

Puerto Rico’s Crushing Debt

On July 1, Puerto Rico defaulted on its debt — the first time a state or Commonwealth has done so since the Great Depression — and did so by failing to pay $2 billion due to creditors. What’s especially astonishing is that the default occurred on general obligation bonds — bonds secured by the actual taxation authority of the municipality. Thus, these are generally considered the safest of all possible municipal bonds. If you can’t tax your way out of debt, you’ve got big problems.

Puerto Rico has big problems, thanks to a crippling recession.

Congress created the Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA), and a seven-person Oversight Board (OB) to right the ship. Governor Ricardo Rosselló was supposed to provide pro-growth reforms as part of this deal.

Instead, in March, PROMESA approved a plan that was a disaster for bondholders, canceling out 23% of the money they were due. That’s called a “cramdown” and in this case, a catastrophic one. Municipal bond funds fell around 2% at the time.

Congress shrugged its shoulders. Congress was happy to pass PROMESA but did nothing to push the Governor or the OB to make more significant cuts in spending, and found itself in a liquidity crisis last March.

This should come as no surprise. Recall that U.S. automaker bondholders were badly crammed down in the auto bailout. The great Todd Zywicki of George Mason University explains why that deal was bad for creditors and the rule of law, and the same logic applies here.

Puerto Rico’s debt will become much more expensive under a stupid deal like this. What lender wants to give Puerto Rico money knowing that the Commonwealth could default again, and they get 23 cents on the dollar? It’ll mean far higher interest rates for any money that does get lent. It will restrict outside capital needed to help get Puerto Rico out of recession.

My private equity contacts tell me that, after the auto bailout, they went on a capital strike that has not abated. They will not invest in companies where similar circumstances exist, in which some gigantic governmental body has the power to wipe them out. That’s one reason the recovery has been so weak, and you can imagine how that will impact Puerto Rico.

This is what happens when politicians get involved in these situations.

Governor Rosselló was supposed to right the ship. It’s why he was elected. The problem is that any politician’s primary goal is to hold onto power. That means short-term thinking and actions and not tough decision-making. What does he care if the bondholders only get 23% of what they are due? He just needs enough money to keep the place running.

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Article printed from InvestorPlace Media,

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