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Puerto Rico shocks, but not yet rocks, muni market

Puerto Rico's brewing debt crisis has pummeled its bonds, but so far not the more than $3.5 trillion broader municipal bond market.

That could change, however, if Puerto Rico's efforts to come to grips with its lumbering $72 billion debt result in default or other negative ramifications that trigger an investor exodus.

Puerto Rico Gov. Alejandro Garcia Padilla late Monday surprised investors when he said the commonwealth needs a restructuring plan for its debt, and he hopes to negotiate a moratorium with bond holders to postpone debt payments for a number of years. He is also pressing Washington to extend Puerto Rico rights to file Chapter 9 bankruptcy, allowed for U.S. governments but not the commonwealth.

A power station of Puerto Rico Electric Power Authority, in San Juan.
Ana Martinez | Reuters
A power station of Puerto Rico Electric Power Authority, in San Juan.

Analysts said they will be watching weekly data on mutual fund flows to see if investors start pulling more money from muni bond funds. Big outflows would could cause the funds to sell other holdings, sending ripples through the entire municipal bond market.

Read MoreIs your bond fund invested in Puerto Rico?

U.S. bond funds had an $11.3 billion total exposure to Puerto Rican debt as of Monday, according to mutual fund firm research Morningstar. As investors adjust to higher interest rates, Thomson Reuters reports municipal funds have already seen outflows, totaling $2.1 billion, over a period of eight weeks.

"I have clients scared to death that they're not going to get back anything on their Puerto Rican bonds." said Dick Larkin, H.J. Sims senior vice president and director of credit analysis. Larkin said it could have a marginal impact on the market, but he expects investors to get some return on their holdings, and possibly even all of it.

Analysts said the Puerto Rican government could be posturing, trying to get better terms on a restructuring of its debt.

"I'm not expecting this to be a tidal wave of defaults, number one, and number two, it's not necessarily guaranteed that Puerto Rico will default. It will depend on how far the government wants to push this. There's the safety valve, if you want to call it that, Puerto Rico still needs to borrow money," he said, adding that it cannot damage its ability to borrow.

Puerto Rico has important debt payments due Wednesday, including $416 million for the Puerto Rico Electric Power Authority, or Prepa, and $630 million of general obligation debt. Analysts expect the payments to be made, but the market has been nervous about them.

"I think if you see a conventional default or if you see a wholesale restructuring of Puerto Rican debt then I think, yes, you could expect there to be a short-term municipal market dislocation," said Jeffrey Lipton, head of municipal bond research and strategy at Oppenheimer and Co. "Having said that, I do not envision a longer-term systemic threat to the municipal market."

If there is a continued outflow from mutual funds, the funds would likely sell their better more liquid holdings which could impact prices of high grade bonds first.

"You've got a market where you've got a major name going down, and nobody wants to feed that," said Blake Anderson, managing director high yield securities at Mesirow Financial. "People will sit in the weeds and see what happens. You don't get price discovery quickly on this."

Hedge funds are active investors in Puerto Rico's debt, and a group holds about 40 percent or about $3 billion of Prepa bonds.

Read MoreInvestors scramble to avoid Puerto Rico losses

"The hedge funds are like the mystery guys. They came piling into this market and looked at it like Southern Europe," said Anderson. "In a market that has no shorts, price discovery gets hard and it's hard to get out of it easily."

Some Puerto Rican bonds were selling for about 68 cents on the dollar Tuesday. An 8 percent 2035 bond, issued three years ago, was yielding 12.77 percent Tuesday, up from 10.75 percent Friday.

Analysts said so far other parts of the municipal bond market were largely unaffected. But tobacco bonds, held by some of the same funds that hold Puerto Rican debt, were trading lower, Anderson said.

"If retail investors start to absorb this and start calling their broker next week, and money on the margin starts to flow out of mutual funds, that's when you'll see portfolio managers sell high-grade stuff," Anderson said. "That's when you'll see spreads start to widen out.... Nobody's going to push high yield stuff into the market when flows are going the wrong way."

John Donovan, senior vice president at Drexel Hamilton, said the credit default swaps on municipal bonds are beginning to show some reaction. On Monday, he said Markit's MCDX index, a basket of 50 five-year CDS on municipal issues, was at 102.67, above Friday's close of 95.99

"If you own a large portfolio of municipal bonds, and Puerto Rico hits, you would go in and buy credit default swaps and pay up a little bit to give yourself some insurance," Donovan said.

Donovan said the headline risk from Puerto Rico could spill over into the broader market. But he said counterintuitively, Puerto Rico may be a positive for some muni names if investors seek to load up other issues.