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US bond funds sue Puerto Rico, worried about bankruptcy threat

U.S. mutual funds holding about $1.7 billion in Puerto Rico debt have sued the cash-strapped commonwealth, accusing it of passing a law modeled after the U.S. bankruptcy code that could undermine the rights of American investors.

Last week's rushed passage of the law has spooked the $3.7 trillion U.S. municipal bond market, sending down prices of revenue bonds issued by Puerto Rico's electric authority. U.S. municipal bonds funds are the largest holders of the island's debt because it is tax-exempt in every state.

A roofless colonial building is overtaken by vegetation in Old San Juan, Puerto Rico.
Alfredo Sosa | The Christian Science Monitor | Getty Images
A roofless colonial building is overtaken by vegetation in Old San Juan, Puerto Rico.

Puerto Rico is one of the largest issuers of debt in the U.S. municipal bond market. Under its constitution, Puerto Rico does not have the power to enact a bankruptcy law for the adjustment of its debts. The complaint contends Puerto Rico passed an act modeled after title 11 of the U.S. Bankruptcy code, which is used by U.S. corporations to reorganize.

Bond funds run by OppenheimerFunds, a unit of insurer MassMutual Financial Group, and Franklin Templeton, filed an amended complaint against the commonwealth on Sunday in U.S. District Court in Puerto Rico.

The debt restructuring law approved last week only applies to some of the U.S. territory's public corporations, most notably the Puerto Rico Electric Power Authority, which has a bond payment due on Tuesday. The law specifically excludes the commonwealth and it Government Development Bank from being able to restructure.

Read More Fed's Dudley sounds alarm over Puerto Rico's high debt load

Puerto Rico's financial leadership put out a statement on Monday reassuring bondholders and investment firms that the law "in no way indicates any shift in Puerto Rico's historical and constitutionally supported commitment to honoring its financial obligations.''

Standard & Poor's Ratings Service on Friday put the entire commonwealth's general obligation and appropriation debt on Creditwatch with negative implications in response to the law.

Moody's Investors Service, meanwhile, said on Monday the law shows the commonwealth's "diminished willingness'' to support the corporations, which it frequently props up. The Puerto Rico Aqueduct and Sewer Authority and the Highways and Transportation Authority (PREPA) have a combined $20 billion in debt outstanding.

Read More Wary governments shake up municipal bond landscape

In their lawsuit, the mutual funds ask a federal judge to declare that Puerto Rico's recently passed Public Corporation Debt Enforcement and Recovery Act violates the U.S. Constitution.

"The Act purports to offer to certain public corporations within the Commonwealth the ability, among other things, to invoke protections from creditors and modify debts,'' the funds said in the amended complaint. "The Act is expressly modeled on title 11 of the United States Code.''

Franklin Funds, a unit of Franklin Resources Inc, holds about $907.2 million in revenue bonds issued by the Puerto Rico Power Authority (PREPA). Oppenheimer's Rochester funds hold about $821.4 million in the PREPA bonds, according to the complaint.

Since the law passed, the price of long-dated PREPA bonds, or those maturing in 20 years or beyond, have dropped by about 15 percent, according to the complaint. Short-dated bonds, or those maturing over the next four years, have fallen as much as 40 percent, the complaint said.

PREPA is also negotiating expiring lines of credit with Citibank and ScotiaBank de Puerto Rico.

Prices on the $3.5 billion in junk bonds Puerto Rico issued earlier this year have been rallying since the law was introduced on Wednesday because investors now expect the commonwealth would not bail out the struggling corporations.

Read More Puerto Rico public workers fight budget law, bond yields spike

The island's financial troubles have also spread to the bond insurance industry. On Monday, New York brokerage BTIG downgraded MBIA to "neutral" from "buy" because of the insurer's $1.531 billion exposure to PREPA debt. MBIA shares fell on Monday.

"The catalyst for the new law was the deterioration of PREPA's liquidity position during the past few weeks as the electricity monopoly has been running out of cash to even purchase fuel and has been trying to renegotiate its lines of credit with its banks,'' BTIG said in a note.

But it said it was maintaining its buy recommendation for Assured Guaranty, which has a $5.34 billion exposure to Puerto Rico's debt, about half of which is subject to the new law. Assured shares were lower.

--By Reuters

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