Can Puerto Rico’s default affect the markets?

This 3.5 million inhabitants’ country will have serious problems the next week. Puerto Rico is pretty small but unfortunately it has a large public debt, around $72Bln. It’s an $100Bln economy, one of the richest in the Caribbean’s region but the central government is having problems to pay $58mln this Saturday. Since the Saturday is not a business day, potentially the payment could be executed on Monday. By many analysts the current level of debt is considered totally unsustainable and the country needs a haircut, at least 40% of the total amount.

The debt has been borrowed principally through municipal bonds and has been financed mainly by the municipal mutual funds. The ten year bond yields have already exceeded the 10% level and for the little country is impossible to refinance its maturing debt. The most important rating agencies have declassed the debt, as the probability to execute the payment on Monday is almost zero percent. At this point, Puerto Rico’s default is no longer in demand but it’s a fact.

This default will be one of the biggest in the recent history of international finance. In fact after Greece and Argentina this will be the third largest public default. Probably the main effects will be in the bond markets and specially in the municipalities bond markets. For some of the American mutual funds that invest in the high yield bond market, this default will be a strong blow . Morning Star has calculated that half of the American municipal mutual funds owns part of this debt. In certain cases some funds have invested 40% of their capitals. For these funds and for the individual investors that have participated the funds, there will be large losses.

We will look to hear about the losses that will come in the different Muni-funds’ investors. From the initial indications, Oppenheimer Funds and Franklin Templeton Investments seem to be more exposed to the country and surprisingly two of the main investors in the Muni-funds, PIMCO and Fidelity seem to be almost absent in Puerto Rico’s debt.

After  Detroit’s and Puerto Rico’s default the Muni Market is getting tougher and investors have to be very selective. The expected rate hike by the FED in November can even worsen the big picture of the high yield bond market and we can expect more failures.

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