How To Play A Puerto Rico Default

While much of the financial world remains focused on economic developments in Greece and China, MKM Partners analyst Harry Fong released a report this week discussing the potential outcome of a default in Puerto Rico.

Fong discussed what he sees as the best path forward for the struggling nation and the lessons that Puerto Rico can learn from Detroit’s recent bankruptcy proceedings.

Something’s Got To Give

A prominent municipal bond fund manager recently suggested that Puerto Rico must cut its total debt from about $72 billion to about $32 billion.

Fong believes that much of Puerto Rico’s debt will ultimately be restructured, but stresses that the government has no authority to force creditors to accept changes to the terms of their debt. Instead, the government must convince debt holders to swap their current debt for new debt with amended terms. Fong believes that this technical default is the most likely outcome in Puerto Rico.

Voluntary Swap

Fong believes that Puerto Rico will likely meet with its bondholders and present them with the details of a voluntary swap proposal. He also believes that many bondholders, including hedge funds, will agree to a swap instead of risking other potential outcomes.

If a swap agreement is not reached, Puerto Rico is at risk of not being able to make its next large debt payment on January 1, 2016.

Learning From Detroit

Fong believes that the hiring of former Detroit Chapter 9 bankruptcy overseer Judge Steven Rhodes is an indicator that Puerto Rico will be using Detroit as a guide throughout its process. However, Fong notes that many if the cities decisions “alienated it from the capital markets,” an outcome that Puerto Rico will likely try to avoid at all cost.

Fong believes that bond insurers will not endure meaningful losses beyond their current levels. Assured Guaranty Ltd AGO is MKM’s top Puerto Rico stock pick.