Rumors about Puerto Rico’s financial problems surface as often as the seasons change. We have been hearing the sky is falling about Puerto Rico for years now. Some say if Puerto Rico was a state of the United States, they would rank 51st (dead last) when comparing the size of their debt to their Gross Domestic Product. It would be the only state rated below A by the three major credit rating agencies. Although the credit rating agencies have their own credability problems.
The fact is there is still enormous demand for Puerto Rico Bonds and with yields hovering around 4% for 10 year maturity dates, these bonds are very cheap compared to other states. The income from Puerto Rico bonds, and by the way most other US territories, is triple tax free regardless of what state you reside. While a New Yorker might have to pay state and city income taxes on a municipal bond issued in California, they do not on Puerto Rican debt. Plus investors get improved diversification if they own too many single state bonds.
Like most states, the constitution of Puerto Rico requires that debt holders be paid before any other expenditures. In theory, bondholders get precedence over paying government workers and pensioners.
Some say the Federal government would step in to make payments, if the Puerto Rico could not. However, when major municipal governments faced loan defaults in the past like the New York City when federal government said Drop Dead to NY’s request.
So what is the risk of owning Puerto Rico bonds? Here is what the naysayers claim…
Puerto Rico is running a budget deficit (the difference between revenues and expenditures) and has amassed about $50 billion in debt and forward obligations (pension liabilities). This is over 100% of the state’s Gross National Product (GNP). This is over 5 times the amount of most states. If every dollar of state government revenue went to repaying debt, and the state did have any expenses, it would take over 8 years to repay the debt, and that doesn’t even include interest costs.
The economy of Puerto Rico is hurting. They are not on path to eliminate the budget deficit which will continue to add to their debt burdon.
Puerto Rico is completely dependent on the continued willingness of investors to lend it more and more money every year. At some point, the appetite of investors will turn away from their bonds, which become increasingly more risky every year as their debt load increases. Until then, investors will enjoy after tax yields that are over twice as much as other Municipal bonds.
More to come on the risks of owning Puerto Rico bonds.