On May 3, Puerto Rican governor Ricardo Rosselló declared the island would look to take its $74 billion debt to federal bankruptcy court. The filing would mark the largest municipal bankruptcy in U.S. history and be five times larger than the record 2013 Detroit bankruptcy.

Economic growth slowed on the island after changes to the tax code began to eliminate enticements for doing business there several years ago. Puerto Rico weakened further after the U.S. credit crisis, and the assets of several banks were seized by federal regulators. The Puerto Rican government borrowed heavily. A federal oversight board recently estimated that the territory can now only afford approximately one-fourth of the $74 billion debt owed to creditors.

Promise Me, Puerto Rico

Puerto Rico is an unincorporated territory of the U.S. Because it is not a state, it is not entitled to Chapter 9 bankruptcy protection. In 2016, Congress afforded Puerto Rico the right to file for a form of bankruptcy protection under the Puerto Rico Oversight, Management and Economic Stability Act (PROMESA)_1.

This was an important action for Puerto Rico. If Congress were to accept a default by a U.S. territory, the decision could potentially trigger state and municipal bondholders to seek higher yields to offset the risk. This would necessitate city and state taxpayers to finance local infrastructure projects at a higher rate.

1 https://www.congress.gov/bill/114th-congress/house-bill/5278/text

Puerto Rico had few options before the passage of PROMESA. PROMESA established a panel to supervise Puerto Rico’s talks with creditors. The act also authorized bankruptcy-like proceedings that would be administered in federal court with the goal to negotiate deals with creditors that a federal judge sees as reasonable.

Restructuring Done Right

The restructuring will proceed under Title III of PROMESA appropriates from the Chapter 9 bankruptcy code. Puerto Rico must demonstrate that it has made an effort at good faith negotiation with its creditors and can oblige disagreeable creditors to a plan that is endorsed by the courts and oversight board.

We believe a best-case scenario for Puerto Rico would result in creditors beginning to settle with the oversight board almost immediately. However, many believe the process could take up to two years. Such a lengthy scenario would ultimately cost even more in legal fees for the island and further dampen Puerto Rican economic activity.

Our Funds

Our funds have limited exposure to Puerto Rico-related issues, as seen in Exhibit 1. We believe our diversified approach should serve investors well, minimizing the impact of the eventual settlement of Puerto Rico’s debts. We remain diligent in evaluating investment opportunities as financial markets react to the news.

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