Puerto Rico faces battle to avoid default

Puerto Rico faces a hot, sticky and tense summer, as the Caribbean island battles to salvage a deal with hedge funds that would keep it financed for another year and avoid a messy default and restructuring. Whether it can dodge that fate has never been more uncertain.

The US territory was forced to turn to hedge funds to fund itself a year ago, after a fiscal crisis and a barrage of credit rating agency downgrades caused its traditional investor base - staid US municipal bond funds unused to the whiff of danger - to flee in droves in 2013-14.

The hedge funds, led by a creditors committee including Davidson Kempner, Monarch and Fir Tree, bought a big chunk of a $3.5bn bond issue last year, and had struck a tentative agreement to back another debt sale as long as Puerto Rico overhauled and increased its sales tax regime.

Yet last week the island's House of Representatives voted down the sales tax bill, despite the Government Development Bank - in practice Puerto Rico's finance ministry - warning that doing so would scupper its chances of returning to bond markets and lead to a government shutdown within three months.

The aborted vote triggered a rout in Puerto Rico's bonds, and many analysts and investors now fear that a default and restructuring is now inevitable.

"It's an overlevered economy with too much debt. There are two ways to get out of that: economic growth or restructuring," says Peter Hayes, head of BlackRock's municipal bond team. "I think there is a growing realisation in Puerto Rico that they have to restructure."

The island's hedge fund creditors are now scrambling to come up with a fallback plan that would still offer Puerto Rico some bridge financing in return for tax hikes and a dose of austerity. "We're working on a Plan B now," said one hedge fund manager. "The money they need isn't that big. They have a deficit problem, not a debt problem."

They also point out that a large chunk of Puerto Rico's $73bn debt pile actually sits with an array of publicly owned companies like Prepa, an electricity provider. But these entities are not guaranteed by the government, and Prepa is already in talks to restructure its $8.6bn of debts. Taking a scalpel - or chainsaw - to these non-government liabilities will chip away at the island's overall debt pile.

Indeed, some investors are still willing to bet on Puerto Rico. DoubleLine's Jeffrey Gundlach revealed this week that he had begun buying the island's municipal debt. He is particularly keen on Puerto Rico's pension obligation bonds, which last traded at just 37 cents on the dollar. "Puerto Ricans have put their savings into them and it would be devastating to restructure them," he told clients at a New York conference.

Hopes of last-ditch reforms and a financing deal, the public vote of confidence by a high-profile money manager and the paucity of high-yielding, tax-exempt investments have helped reverse some of last week's sell-off. The $3.5bn bond due in 2035 fell to a low of 77.5 cents on the dollar, but is now trading at 79.3 cents.

The GDB and the government "continues to work closely with the legislature to strengthen the commonwealth's fiscal position and ensure there is no disruption in the commonwealth's operations", Barbara Morgan, a spokeswoman, said in a statement.

Nonetheless, Puerto Rico's hedge fund creditors clearly do not feel completely confident. The group is in the process of hiring a litigation law firm, a sign that they are girding themselves for a potentially combative restructuring.

Even if an austere 2016 budget allows Puerto Rico to issue another bond, it would only represent a temporary reprieve. Tax hikes and spending cuts will weigh on the already weak economy, accelerate the exodus for the US mainland and in turn crimp the government's finances further.

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Yet a restructuring is likely to be extremely tough, time-consuming and painful for both debtor and creditor. Puerto Rico's debts are a tangled knot of direct, guaranteed or implicitly-backed obligations, many with legally challengeable first dibs on specific revenue streams.

Nor can Puerto Rico count on a kindly creditor group. Many of the hedge funds involved are aggressive distressed debt investors with reams of experience in legally tortuous restructuring situations, and are unlikely to back down without a fight. But the chances of avoiding one are receding.

"The dance is all about whether it comes this year or next," says one prominent restructuring lawyer who was involved in Detroit's bankruptcy. "The level of debt is insane."

Ted Hampton, Moody's lead analyst on Puerto Rico, points out that the crunch could come soon, given that the government is running dangerously low on cash and faces a looming budget battle. "There is a high and growing risk of a consolidated restructuring of all the government's debts," he warns. "This is a very serious debt crisis playing out."

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