Puerto Rico Implodes

Anyone invested in the municipal bond market should keep an eye on Puerto Rico which declared a special form of bankruptcy allowed to it by Congress in a special law passed a couple of years ago. The territory, where population has been declining for decades, borrowed a virtual boatload of money in the last ten years, propelled by a very irresponsible government. The net result is an enormous and growing debt load per person – and since Puerto Ricans are US citizens, all they need to do to escape this debt is to move to the mainland, which they are doing in droves. Of course, this exacerbates the debt load for those remaining.

Some 45% of Puerto Ricans live in poverty. No, that is not a typo. And most of the rest of its citizens work for the government, which now has to go on a drastic diet, so you can see what’s coming down the pike. Not anything good.

Investors in municipal debt are sometimes – rarely, but sometimes – stung by default events like Puerto Rico’s. Usually, except for very small niche-y situations, these train wrecks are thoroughly visible long before they happen, as was Puerto Rico’s. The normal course of events – if there is a normal – is that the claims of creditors, including bond holders, are settled by the courts. While case law is slender in this arena, lessons from Detroit, Vallejo, and others teach us that anything can happen in court. Basically, once a municipal bankruptcy occurs, you can bet that the return on your bonds is very likely to experience a severe haircut. Even when bond indentures establish a claim that appears to be prior over another claim, if there isn’t enough money, there isn’t enough money and everyone is going to experience pain.

Among the claimants, too, are pensioners, current workers, and vendors. None of these parties may directly own bonds, but they will be sharing the same pot of money as bond holders, and will find themselves reluctant participants in the court process.

The events in Puerto Rico are particularly noteworthy not just for the outcome on the island – the court case will also add to law that may be used by Hartford Connecticut, which is well on its way to its own special train wreck, and possibly Illinois, which is becoming intractable. We shall see what happens.