Puerto Rico Bondholders Put Their Trust in Wrong Ally

(Bloomberg Gadfly) -- Holders of Puerto Rico's bonds are getting a harsh lesson in being careful what they wish for.

Investors cheered last year after U.S. lawmakers created a fiscal oversight board for Puerto Rico, with the goal of putting the island's finances in order. Traders pushed up Puerto Rico debt values by more than 5 percent in the four months after June. This new oversight committee was going to be great for bondholders.

But a funny thing happened on the way to the payday.

On March 13, the federal oversight board approved a budget that devoted much less money to debt investors than markets had anticipated, and traders' sentiment shifted rapidly. Bond prices plunged toward record lows. Values still have much further to fall if this budget is anything close to a final version.

Investors in the island's $70 billion of debt are realizing they probably won't get back nearly as much money as they had priced into their assumptions. And it's looking less likely investors will reach any out-of-court agreement with one another because they have a much smaller pool of money to fight over.

This financial plan, proposed by Gov. Ricardo Rossello, delivered two blows.

First, Puerto Rico budgeted just $404 million toward servicing its debt in fiscal year 2018, compared with $3.3 billion of scheduled payments, according to Municipal Market Analytics analyst Matt Fabian. That implies an estimated repayment of about 20 to 25 cents on the dollar for Puerto Rico's general obligation bonds compared with current market prices of more than 60 cents, according to Chris Ryon, a municipal bond portfolio manager at Thornburg Investment Management.

And second, the relatively new fiscal control board showed that it wasn't going to be particularly sympathetic to credit investors, creating more confusion about how to value the securities.

Rossello exacerbated pessimism among bondholders when he sought to revisit an agreement struck with creditors of the island's Electric Power Authority more than a year ago. The goal is to foist more losses upon them. Rossello will testify before Congress about the issue on Wednesday.

This mess extends well beyond the borders of the long-suffering island. The owners of Puerto Rico bonds include not only its residents but many U.S. municipal-bond mutual funds, including Franklin's High Yield Tax-Free Income and the Oppenheimer Rochester Maryland Municipal Fund. Both of those funds are substantially underperforming their peers this year.

And then there are the big hedge funds that plowed into Puerto Rico debt as many mutual funds fled, hoping to win out in some sort of restructuring or as sentiment improved. These funds may end up seeing some rewards, but if they ever do, it won't be for a long time. The island has already stopped paying interest on some of its debt and will most likely stop making payments on other bonds in the near future.

Anyone who's left in these bonds had better be prepared for a long, drawn-out process. It's all about recoveries at this point. That friendly fiscal control board didn't turn out to be so chummy after all.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Lisa Abramowicz is a Bloomberg Gadfly columnist covering the debt markets. She has written about debt markets for Bloomberg News since 2010.

To contact the author of this story: Lisa Abramowicz in New York at labramowicz@bloomberg.net.

To contact the editor responsible for this story: Daniel Niemi at dniemi1@bloomberg.net.