Hedge funds look for a plan B for Puerto Rico's debt

Puerto Rico's hedge fund creditors are scrambling to cobble together a "plan B" for the indebted island, after a deal to fund the US territory collapsed last week.

The group of creditors have also hired a litigation firm and warn that any debt restructuring will be messy and tough after a bill paving the way for a new bond sale was defeated in Puerto Rico's House of Representatives last week.

That rejection leaves the island on course for a government shutdown as its coffers run dry, hammering the price of its bonds. The $3.5bn bond due in 2035 now yields 10.5 per cent, above where Greece's equivalent bond is trading.

The hedge funds hope a back-up plan can be formalised to give them enough confidence to resurrect the bond sale and tide Puerto Rico over for another year. This would involve lifting the sales tax rate by several percentage points - rather than overhauling the system completely - and credibility-boosting spending cuts.

"Things could change but if they can get a plan together to close the budget deficit [over the next two years] then we'd be happy to lend to get them to that point," said one hedge fund manager. "They'll do something watered down to keep them going until 2016 when there is a new election."

However, time is running short ahead of the presentation of the budget for the next fiscal year by July 1, and the hedge funds have hired a litigation firm - Washington-based Robbins, Russell, Englert, Orseck, Untereiner & Sauber - in case Puerto Rico decides to default and restructure its debts.

While it might be politically easier to restructure when much of the debts are held by hedge funds rather than municipal bond funds, they enjoy legal protections that would make it a messy battle, hedge fund managers said.

"Restructuring is not the easy way out. It will not be served on a silver platter," one money manager warned. "Puerto Rico can't cram down bondholders easily, they would have to get cute. It's easier to stick it to hedge funds than muni investors, but technically it's not easy."

The hedge funds hold about $4.5bn of Puerto Rico's government or government-guaranteed debt, and are led by a creditors' committee including Monarch, Fir Tree, Davidson Kempner, Centerbridge and Perry Capital.

Puerto Rico's bonds have recovered some of their footing this week after Jeffrey Gundlach, a widely-followed bond fund manager at DoubleLine, said he was buying the island's debts on the view that the recent sell-off was too extreme. Puerto Rico's governor has also said that defaulting would be "folly".

However, other investors reckon that the rout could be renewed as the crisis deepens and makes a convoluted, complex and drawn-out restructuring battle more likely. "We think it's a matter of when, not if," said Peter Hayes, head of municipal bonds at BlackRock. "We're beginning to see the crunch now."

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