Puerto Rico's Debt Woes Could Spread

The novela that is Puerto Rico's debt drama continues.

On Monday, the struggling Puerto Rico Electric Power Authority made a deal with its bank lenders to delay certain payments on its credit lines. That provides Prepa with a bit of breathing room while it negotiates terms with its bankers on their $800 million in credit lines needed to finance the purchase of fuel oil to power its generators.

But the effects of legislation to allow restructuring of the debt of the U.S. territory's so-called public corporations continue to ripple through the municipal bond market. Thus far, those ripples have been contained, with little spillover into the broader muni market.

That could change, however, when holders of tax-exempt bond funds -- especially the high-yield variety -- get their June 30 statements. How these individual investors react to the funds' declines from their exposure to Puerto Rico debt could hit the broader muni market if funds are forced to liquidate bonds to meet shareholder redemptions.

Selling by large institutions, including hedge funds, drove down prices of Puerto Rico securities. Municipal Market Advisors managing director Matt Fabian pointed to the spike in large trades in Puerto Rico-related bonds at prices under 50 cents on the dollar following the downgrade by Moody's Investors Service last week (discussed in this week's Barron's print edition.)

As a result, Fabian writes, some high-yield muni funds may have given back one-third of their gains scored so far this year. Mutual funds' valuations depend on the latest prices, which may reflect a relative handful of recent trades. In the stock market, thousands of trades make it simple to determine a price of a company's shares. In the bond market, it's more akin to residential real estate, in which a few comparable transactions, or "comps," provide an inexact guide to valuations.

Moreover, he continues, as funds with heavy exposure to the commonwealth sell non-Puerto Rico credits to meet redemptions, their PR concentrations will rise. To be sure, many of the biggest fund companies long ago slashed their holdings of Puerto Rico-related bonds and should be relatively unaffected. But, as the tide goes out, some fund holders may be surprised they were exposed, to paraphrase Warren Buffett's metaphor.

Fabian also posits the passage of legislation to restructure Puerto Rico's public corporations' debt also could have implications for other U.S. territories, notably Guam and the U.S. Virgin Islands. The latter have a tiny fraction of the $70 billion-plus of debt that Puerto Rico's entities have outstanding, but their obligations are highly sought-after because of the tax-free status of their interest in every state and locality as well as from Uncle Sam. Fabian suggests investors should consider selling their Guam and Virgin Island bonds before the market realizes the risks of those territories' following Puerto Rico's lead to enact legislation to permit restructuring of their debts.

As Barron's has previously reported, the various bond insurers have significant exposure to Puerto Rico, which has been reflected in the hits to stock prices of MBIA ( MBI ) and Assured Guaranty ( AGC. ) But, MMA observes, even if Puerto Rico bond holders and the bond insurers fare as poorly as they might, insured PR bonds will likely see a full or near-full payment.

Beyond that, MMA doubts Puerto Rico's debt straits major few implications for most muni issuers, which mainly use the market to fund infrastructure projects and not to paper over budget deficits. Even if there is greater scrutiny of credits, Fabian writes "there are very few fish to be caught in these tighter nets."

But there could be future implications for the tax exemption of munis. As I noted in my column last week, Puerto Rico's ability to borrow so promiscuously was enabled by investors' demand for high triple-tax-free income, which led them to turn a blind eye to the excess indebtedness of the commonwealth and its public corporations. The implicit subsidy comes at a cost to the U.S. Treasury and has helped facilitate the over-borrowing, which may result in political blowback, including from anti-debt Tea Party types.

That demand resulted in Puerto Rico-related bonds comprising a lopsided portion of the long-term muni market. Fabian writes that PR credits account for 15% of all current tax-exempt bonds with maturities of 30 years or more, and 30% of all maturities of 40 years or more. "Meaning PR's rampant deficit financings account for a significant chunk of tax-exemption's future cost to the U.S. Treasury," Fabian writes.

Clearly, Puerto Rico finally is facing the cost of putting off expenses to manana.

As mid-year statements go out, muni-fund redemptions could force selling of other credits.

ByRandall W. Forsyth

Puerto Rico's Debt Woes Could Spread - Barron's