Markets

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

When you play chicken, sometimes you get smacked.

So it goes for creditors of Puerto Rico, which just hardened its stance considerably as it seeks to reduce its $74 billion mountain of debt.

The island moved on Wednesday to start bankruptcy-like proceedings that will most likely foist bigger losses on debt investors than they've been willing to accept. This is a big step. This restructuring is poised to be the biggest ever for any U.S. local government. And it could only happen because Congress last year designed a new and relatively untested mechanism called Title III specifically so Puerto Rico could enter court-restructuring proceedings.

Based on the lack of price movement in Puerto Rico's bonds on Wednesday, it might seem initially as though investors shrugged this step off as just another blip in an incredibly messy and drawn-out negotiation.

Precipitous Fall
Puerto Rico's bonds have fallen as the island's finances deteriorated
Source: Bloomberg

But don't be fooled by that veneer of calm. Investors are clearly becoming more concerned. It won't take much for these bonds to trade lower in the coming weeks. 

It wasn't supposed to get this far, though the possibility grew as talks dragged on. The legal cudgel that lawmakers gave Puerto Rico last year was expected to force creditors to come to some out-of-court agreement. It was meant to be the last option that was so onerous to bondholders that it would force them to the negotiating table despite the more than a dozen debt issuances with competing claims on the island's revenues. 

Going to federal court was only supposed to happen after Puerto Rico failed to reach an agreement after it engaged in good faith efforts. There were certainly negotiations, although the sincerity of those intentions is open to debate. And now, just days after Puerto Rico lost temporary immunity to lawsuits, the island took out the hammer.

Puerto Rico has signaled that it plans a one-and-done approach to bankruptcy, according to Sean McCarthy, head of the municipal credit research team at Pacific Investment Management Co. That means the island and its overseeing judge will try to shrink the total amount of debt enough so that it has some reasonable chance of thriving afterward.

Already, Puerto Rico bondholders have started to realize that the fiscal board put in place by Congress to oversee the island's finances isn't particularly friendly to their desires. Indeed, this board budgeted just $404 million toward servicing the island's debt in the 2018 fiscal year, compared with $3.3 billion of scheduled payments, according to Municipal Market Analytics analyst Matt Fabian.

Dwindling Recoveries
Puerto Rico's oversight board has budgeted to repay just a fraction of debt owed
Source: Bloomberg, Puerto Rico Fiscal Agency and Financial Advisory Authority

The full certified 10-year fiscal plan is draconian toward debt investors. And any judge overseeing the restructuring proceedings will consider these financial assumptions as a starting point for when the oversight board reconfigures Puerto Rico’s obligations, McCarthy said.

Continuing Slump
Puerto Rico's economy has been contracting for years as it boosted its debt
Source: World Bank Group

At some point, even as some hedge funds and others hunker down for a long, expensive battle, some investors will decide they want out and will try to sell their bonds. This is especially the case for some debt that has stopped generating regular coupon payments, making it expensive to hold. That's when creditors will start to find out how much it hurts to get smacked by a hammer.

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

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