How Does Puerto Rico’s Default Impact Bonds?

August 6, 2015

On August 1, Puerto Rico defaulted on its $70 billion in outstanding debt – the first default in the U.S. territory’s history. Baird Senior Fixed Income Research Analyst Dave Violette discussed how the default impacts the fixed income market.

First off, this default is not a surprise – given that Puerto Rico is experiencing a localized recession, the territory’s default on its Public Finance Corporation debt is likely only the first in a series of defaults among its more than 15 public entities. Similar to what we saw with Detroit, the default process will likely require litigation and negotiations between the territory’s creditors and debtors, which is anticipated to be both lengthy and messy due to the sheer volume of debt outstanding. Because widespread default is all-but-unavoidable, the appropriate question to ask isn’t What recovery will bondholders realize relative to their coupon rates? Rather, the question is What recovery will bondholders realize relative to today’s prices?

Unfortunately, this question will only be answered in the above-mentioned litigation and negotiations, and estimates today will be based on a great deal of uncertainty and guesswork. Moody’s is basing its current ratings of all credits in Puerto Rico on a 35–65% recovery on Ca-rated credits and 65–80% recovery on Caa3 credits, which includes GO, COFINA Senior, PREPA and PRASA. Anticipation of Puerto Rico’s default has long been priced in the market, so we expect both a limited impact on the municipal market and limited incremental downside.

It is important to note that high-yield muni funds, which hold Puerto Rico and tobacco debt, have experienced an increase in outflows, and additional pressure on those types of credits can be expected. The impact of Puerto Rico’s default on other sectors, however, is probably muted – just part of the general noise surrounding interest rate and credit concerns.

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