When some of Wall Street's savviest hedge funds piled into Puerto Rico's debt in 2014, it seemed like an easy bet: Buy up the island's bonds at a discount, pocket the high interest and persuade politicians to make decisions that would raise the value of their investments.
Even if Puerto Rico's economy collapsed and its government unraveled, the investment funds figured they had an ace in hand. Puerto Rico was a United States commonwealth, and thus — like the 50 states — legally barred from declaring bankruptcy as a way to shed its debts.
But that safeguard was all but wiped out this week. On Wednesday, Puerto Rico essentially filed for bankruptcy in federal court, under a law Congress passed last summer to help the island cut its debt and escape financial calamity.
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In taking this drastic step, Puerto Rico asserted that it had no way to pay the $123 billion in bonds and pension debt it owes.
The unprecedented legal filing came only a few days after hedge funds and other holders of Puerto Rico's general obligation debt thought they had cut a deal with the government to avoid bankruptcy.
The move represented one of the lowest points in Wall Street's long, torturous history of investing in Puerto Rico's bonds. The hedge funds have been battling to protect their investments through the administrations of two Puerto Rico governors and across Capitol Hill, keeping an army of lawyers,
"I don't think anyone bargained for this," said David D. Tawil, a co-founder of Maglan Capital, a New York hedge fund that had at one point invested in Puerto Rico's debt. "I think most funds expected there would have been a consensual agreement by now."
It does not take long to see why a solution to Puerto Rico's debt problem has eluded the hedge funds and other investment firms that own the island's bonds: Many of the creditors think they are, or should be, first in line for the money. But the island also has to keep paying its police officers and its teachers while it struggles to raise revenue.
Two bondholder groups in particular — owners of general-obligation bonds and owners of Cofina bonds, which are backed by sales tax revenue — are at odds. Each of those types of bonds, their investors argue, carries protections that put those bondholders at the top of the pecking order after a default.
Puerto Rico's general-obligation bonds are backed by a provision in the island's constitution that promises that if there is not enough money in the general fund for all planned expenditures, general-obligation bonds will be paid off before anything else.
That sounds good, but investors in the
The money goes straight from the merchants to a trust — not to Puerto Rico's treasury — so the government cannot lay claim to it and use it for anything else, such as paying the general-obligation bondholders.
With both the general obligation bondholders and the
A law passed last summer under the Obama administration, called Promesa, was designed specifically to address Puerto Rico's predicament. It created a bankruptcy-like process that the island and other United States territories could use to restructure their debts.
Bondholders fought vigorously on Capitol Hill to derail the legislation but lost. They did win a few concessions in the makeup of the fiscal oversight board that would oversee the government's attempts to cut expenses. For instance, it would have to include three members from a list of people picked by Democrats and four picked by Republicans. That way, some bondholders figured, they could expect a more creditor-friendly approach.
But the bill that was finally enacted had many elements that could harm bondholders, including a "cramdown" provision, which gives a bankrupt government the power to force a deal on an unwilling creditor.
To investors — who bought the bonds assuming their legal protections were ironclad — it seems as though the governments in San Juan and Washington are constantly moving the goal posts.
Hector Negroni, co-chief executive of FCO Advisors, which is invested in Puerto Rico bonds, said the oversight board had failed to honor constitutional protections for bondholders and to carry out its duty to force the government to tighten spending.
The board's actions, he said, are hurting not only
"We were promised Promesa wouldn't change the rules against creditors," Mr. Negroni said. "Here we find ourselves with a board that has attempted to force a solution on us that does the exact opposite."
Do not count the hedge funds out just yet. Puerto Rico may have veered from Wall Street's preferred playbook, but some of these hedge funds employ skilled dealmakers and relentless litigators.
Those firms include Aurelius Capital, which was among
The hedge funds are not the only investors in Puerto Rico's $74 billion in bonds. Those bonds had been a staple of retirement funds across the United States, generating hefty yields for mom-and-pop investors at a time of
Those retirement funds had been assured that Puerto Rico had little choice but to honor its debts — even as the island's pension costs swelled and its tax revenue ebbed. Mutual fund managers like Oppenheimer and Franklin Templeton are now fighting for repayment alongside the hedge funds.
It is too early to say whether the hedge funds will end up losing money on their investments, as they bought many of them at a discount.
Before the bankruptcy filing, general obligation bondholders were close to a deal with the government that would have valued their debt at 70 cents on the dollar, according to people briefed on the matter.
On Thursday, many of those bonds were trading around 66 cents on the dollar, according to Municipal Market Analytics.
Mr. Tawil of Maglan Capital said many investors had made the mistake of comparing Puerto Rico to an insolvent nation. But nations are typically bailed out by the International Monetary Fund before they collapse totally.
No such bailout has come for Puerto Rico. As a commonwealth of the United States, Puerto Rico does not qualify for I.M.F. assistance, and there was little appetite in Congress for a wholesale federal rescue. For months, investors and residents have been in a "five-ring circus," as Mr. Tawil put it, where bondholders are fighting with the government, the control board and one another.
Even so, Mr. Tawil is considering investing in the debt again. "We are in this unknown territory," he said. "How this all ends is unclear."