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As Puerto Rico default looms, questions about insured bonds

With Puerto Rico saying it simply cannot pay its $72 billion debt, investors are increasingly worrying about whether bond insurers can cover a looming default. But some experts believe that those holding insured municipal paper from the island should not be worried. (Tweet This)

A Puerto Rican flag flies from a building in San Juan, Puerto Rico.
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A Puerto Rican flag flies from a building in San Juan, Puerto Rico.

"The ... major bond insurers of Puerto Rican bonds ... could probably handle a Puerto Rico default, depending on how much (the government) is willing to negotiate with bondholders," Richard Larkin, director of credit analysis at financial services firm HJ Sims, told CNBC. He added that holders of insured bonds should be in "good shape."

The insurers Larkin was referring to are Assured Guaranty and MBIA-owned National Public Finance Guarantee. Both National and Assured Guaranty told CNBC that their investors should not worry about a Puerto Rico default.

"National Public Finance Guarantee Corp. will continue to work with the appropriate parties toward a solution that addresses Puerto Rico's significant fiscal and operational difficulties while respecting the rights of creditors. In the meantime, National will ensure that its policyholders will continue to receive all of their scheduled interest and principal payments on time and in full," the insurer said in a statement.

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Robert Tucker, head of investor relations and communications at Assured Guaranty, said in a statement that "We will continue to negotiate in good faith but will not hesitate to fully exercise all of our rights and remedies. As always, investors in Assured Guaranty insured bonds can rely on our $12 billion in claims-paying resources and unconditional and irrevocable guaranty of the scheduled payment of principal and interest when due."

Larkin made his remarks a day after Puerto Rico Gov. Alejandro García Padilla called out the island's creditors in a speech, saying they had to share in Puerto Rico's sacrifices.

Puerto Rico owes a payment of $1.055 billion by Wednesday and must also approve an annual budget. "I don't think the default is coming tomorrow," Larkin said, but added that "all Puerto Rico bonds remain at risk after the governor's remarks."

"There is no reason why we won't be meeting those obligations in the near term," Pedro Pierluisi, the island's representative in Congress, said in a CNBC "Power Lunch" interview. "There is so much we can do and should do right now, next year and the following year. When we talk about the central government, its revenues range close to $9 billion a year."

The governor made the speech after telling The New York Times that the island's debt is not payable, sending MBIA and Assured Guaranty shares down about 23 percent and 13 percent in Monday trading, respectively. MBIA's stock was down more than 5 percent in Tuesday afternoon trading—off morning lows—while Assured Guaranty was slightly higher.

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The island's bonds have fallen sharply on the news for two straight days, as general obligation 8 percent bonds maturing in 2035 traded as low as 64.50 cents on the dollar on Tuesday, down from 69 cents Monday, according to Reuters.

Following García Padilla's remarks, Standard & Poor's Rating Services dropped Puerto Rico's rating from "CCC-plus" to "CCC-minus."

Bankruptcy only way out, but ...

Steven Rhodes, a former U.S. bankruptcy judge who oversaw the Detroit bankruptcy case, said Monday that the island needs the ability to restructure under Chapter 9. "It can no longer pay its debts, it will soon run out of cash to operate, its residents and businesses will suffer," Rhodes said.

Puerto Rico, however, legally can't declare Chapter 9 bankruptcy and restructure its debt, since it is a U.S. territory rather than a state.

Last February, Pierluisi, introduced HR 870, a bill that would let its municipalities and public corporations declare bankruptcy under Chapter 9. The bill, however, is unlikely to pass.

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"The perception is that, if you give Puerto Rico the authority to file for bankruptcy, that's the equivalent of a federal bailout, and that taxpayers in Iowa, in Texas and Alaska are authorizing federal funds to be spent to bail out Puerto Rico," Frank Shafroth, a professor specializing in municipal bankruptcy at George Mason University, said at a June 15 conference.

In his Monday speech, García Padilla urged Congress to turn the bill into law, as it was the only way for the island to crawl out of its fiscal hole.

Nevertheless, Luis Fortuño, Puerto Rico's former governor who lost an election to García Padilla in 2012, said Tuesday that the current governor's remarks further dissipate the bill's chances of passing.

—Reuters contributed to this report.