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Is the Collapse of Puerto Rico Bonds a Harbinger of Things to Come?

Posted: Nov 12, 2013 | Posted in:

Puerto Rico bonds have suffered major losses this year, with many mutual fund investors facing shocking losses as the bonds were downgraded and concerns mount that Puerto Rico will default.   Coupled with imminent bankruptcy in Detroit, the bond market in general has suffered because of concerns that municipal bonds are risky.   The problems with Puerto Rico bonds have some experts expressing concern that things are going to get even worse in the future.

Puerto Rico Bonds May be a Signal of Big Problems to Come within the U.S.

While much of the media’s attention is on the impending bankruptcy in Detroit, the reality is that the disaster in Puerto Rico is likely to be a much bigger problem for investors and the economy.  As The New American reports, Detroit’s debt amounts to around $18 billion.  This may seem like a high debt level, but Puerto Rico has $70 billion in outstanding debt that the territory may default on.

Factors contributing to Puerto Rico’s high debt levels include:

  • The high minimum wage rate which makes hiring too expensive and has resulted in an unemployment rate nearly twice that of the rest of the United States.
  • National debt that exceeds the debt owed in any American state except California and New York.  Puerto Rico’s population of just 3.6 million cannot support this volume of debt.
  • Low participation in the labor force (41 percent participating).
  • Puerto Rico’s generous disability and welfare programs are believed by some to discourage employment.
  • A large government workforce.  One employed person out of every five works for the government.

Failing to pay the debt has resulted in the downgrade of Puerto Rico bonds to a level just above junk bonds.  None of these factors are a surprise or were unknown, and mutual fund managers who made the choice to load up on Puerto Rican debt should have been (and likely were) aware of the tremendous risks.  Yet, financial advisors still invested billions in Puerto Rico bonds, often without alerting the individual investors of the risks.

Investors in the U.S. face huge losses and potentially more losses are on the horizon if Puerto Rico bonds are downgraded further.  An article published by The New American expresses concern that the entire United States is on the track that Puerto Rico is currently on.  A former investment advisor and Cornell graduate writing for The New American blames the Puerto Rico bond problems on “government interference, subsidies, wage laws and special incentives,” many of which are the same conditions that exist in the U.S. today.

Whether this is true and the Puerto Rico market is a bad sign for the bond market, and whether more municipalities and government units throughout the U.S. are sinking into too much debt remains an open question.  One thing is clear however: major mutual funds will no longer be absorbing Puerto Rico’s debts, and it is investors who are likely to be the big losers.  These investors can try to recover losses from their fund managers, but someone is going to have to pay for the massive losses from debts when Puerto Rico cannot meet its obligations.