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Why Puerto Rico's debt crisis isn't contagious

Puerto Rico's growing debt crisis has raised fears among investors about the safety of the $4 trillion municipal bond market. However, according to some bond watchers, those fears may be overblown.

"Puerto Rico is a different animal," said Ben Thompson of Sampson Capital.

As a result of Puerto Rico's commonwealth status, its bonds enjoy triple tax-free status, meaning that owners of those bonds pay no federal or state taxes. In contrast, most muni bonds only enjoy tax-free status in the state in which they are issued.

A delivery man pushes a cart through a street of San Juan, Puerto Rico.
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A delivery man pushes a cart through a street of San Juan, Puerto Rico.

For example, a New York resident who purchases California municipal debt will most likely have to pay New York state taxes on that bond.

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"Puerto Rico is more widely held because of its tax status," added Thompson, who oversees over $7 billion in tax-free debt for Sampson Capital, a boutique investment advisory firm. "Most muni bonds are held by people who live in the local area, but if there is a lack of supply, you might look to areas that offer tax-free debt," added Thompson.

Puerto Rico's generous tax treatment, combined with its higher coupons, have made Puerto Rico's debt popular among yield-hungry investors.

The most liquid Puerto Rico bonds yield close to 12 percent. By contrast, a AAA-rated New York State Muni bond with similar maturity yields yield about 3.5 percent, according to Municipal Market Data.

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What Puerto Rico's debt crisis does illustrate is the dangers of excessive borrowing, say some market participants.

"Governments are borrowing too much," said Larry McDonald, head of U.S. Macro Strategies at Societe Generale.

According to McDonald, the real threat behind Puerto Rico is that it could lead to skittishness in the tax-free debt market, which could cause higher borrowing costs among issuers.

Still, at $78 billion, Puerto Rico's outstanding debt represents a tiny slice of the overall $4 trillion municipal bond market.