Puerto Rico nears default as debt restructuring beckons

Why Puerto Rico's debt crisis matters...

Puerto Rico's expected default on debt due Saturday would be the start to what could end up becoming one of the largest municipal restructurings, with the potential to open the door to a fight with investors and spark volatility in bond prices.

Puerto Rico Governor Alejandro Garcia Padilla shocked investors in June when he said the island's debt—totaling $72 billion—was unpayable and required restructuring.

Puerto Rico has flagged that it will likely skip a $58 million payment due Aug. 1 on its Public Finance Corporation (PFC) debt, which has weaker investor protection than some other bonds.

Read More Puerto Rico bonds: Great upside, but buyer beware

"What could surprise investors is when they actually hear the word default, and that a default occurred," said Lyle Fitterer, head of tax-exempt fixed income at Wells Capital Management, which holds mostly insured Puerto Rico debt.

"The immediate reaction might be a slight sell-off in the marketplace because I think people will start to anticipate, OK, what's the next series of debt they're going to default on?"

It would mark the first missed debt payment. According to a 2014 bond offering statement, Puerto Rico has never defaulted on the payment of principal or interest of debt.

A non-payment would be the most notable since Detroit, which had about $8 billion of bonds, defaulted on $1.45 billion of insured pension bonds before it filed for bankruptcy in 2013 and then on more than $600 million of general obligation bonds.

Puerto Rico's chief of staff Victor Suarez said Monday that the commonwealth did not have the current cash flow to pay the PFC bonds.

Read More Why US may not help Puerto Rico

"I bought my (PFC) bonds with the anticipation of them defaulting," said Ben Eiler, managing partner at First Southern Securities in Puerto Rico. "They're going to restructure in some form or fashion and I believe that restructure is going to be higher than that level."

PFC bonds due 2031 traded Thursday at 15.55 cents on the dollar.

However, there remains a question over whether Puerto Rico will meet a $169.6 million Government Development Bank (GDB) debt payment, also due Aug. 1. Suarez has said the island will do "everything that is possible" to ensure that it is paid.

"People are split on the GDB - if it pays it may be positive on a short-term perspective," said John Miller, co-head of fixed income for Nuveen Asset Management. If it fails to pay, it could be a negative sign for debt such as its general obligation debt, said Miller.

Puerto Rico's debt: What we know

The upcoming restructuring is leading investors to wonder how Puerto Rico will prioritize debt payments versus citizens' needs.

"We're beginning to discern a... mindset on the island that the government is weighing the interest of investors against the economic interest of the island," said Thomas McLoughlin, UBS chief investment officer wealth management research.

Default debate

Suarez told reporters in San Juan Wednesday that a missed payment would not constitute default. Bond documents state that Puerto Rico's legislature is not legally bound to appropriate the funds to pay.

However, credit rating agency Standard & Poor's said it would view a non-payment on rated PFC bonds on their due date as a default. Moody's said it would also consider it a default.

"It (would be) the first failure by the government to pay on a debt to public investors and indicates the weakness of the government's ability and willingness to pay," said Timothy Blake, managing director of Moody's Public Finance Group.

A default could open the door to a fight with investors, although that may be uphill.

"Our reading of the legal documents is that bondholders have very limited remedies," said David Hitchcock, analyst at S&P. "Puerto Rico could potentially just ignore the bondholders."

Read MorePR debt: With few options left, 'People are going to leave'

Whether Puerto Rico defaults may not be known until Monday. According to PFC documents, a payment falling on a weekend can be made on the next business day.

Officials may give information after a scheduled meeting by a working group created by the governor, set for 1 p.m. EDT.

"It's going to be a long process, a very long, drawn out process," said Michael Comes, portfolio manager and vice president of research at Cumberland Advisors in Florida, which holds insured Puerto Rico debt. "It's kind of like watching the Titanic sink."

Related Tags