While many eyes are turned to Greece's economic meltdown, there's another problem child closer to home.
Puerto Rico is standing on the financial precipice, with Gov. Alejandro Garcia Padilla warning last weekend that the island's debts "are not payable." He warned that the island of 3.6 million residents will enter a "death spiral." On Monday, he sought negotiations with bondholders to delay debt payments and restructure $72 billion in public debt.
Like Greece's financial problems, Puerto Rico's issues are likely to have a ripple effect far outside its borders. People who own mutual funds and ETFs that are invested in the island could end up losing money, such as the $1.6 billion Market Vectors High-Yield Municipal Index ETF (HYD), which has invested in Puerto Rican bonds. Hedge funds and U.S. investment firms such as Brigade Capital Management also hold billions in Puerto Rican debt, according to the Wall Street Journal.
"The situation is dire, and I mean really dire," said Anne Krueger, a former World Bank chief economist who worked on a report commissioned by Garcia's administration about the crisis.
Below are five things U.S. investors need to know about the crisis.
How did Puerto Rico end up in this situation? Blame it on a combination of long-term economic stagnation and a number of financial stresses, including a housing bust. The island also suffered from weak public finances and overly optimistic revenue projections, according to Krueger's report.
Another factor is that government aid can provide Puerto Rico residents with $1,743 per month in benefits, compared with the average take-home earnings on the island of of $1,159 per month for a minimum wage worker. That can act discourage people from seeking work. The unemployment rate in Puerto Rico stood at 12.4 percent in May, or more than double that of the U.S.
Even worse, the island has suffered from "outmigration," with middle-class people leaving for better opportunities elsewhere. That's weakening Puerto Rico's economic base.
Can Puerto Rico file for bankruptcy? Only U.S. cities and municipalities, like Detroit, are allowed to declare bankruptcy, so under current law this isn't an option for Puerto Rico. It can negotiate and settle with creditors, although that could be a long, drawn-out process. The White House has dismissed the idea of bailing out the island, although the administration has urged Congress to change the law to allow its government and public agencies to declare bankruptcy.
How many U.S. funds are affected? There are an estimated 377 out of 1,884 bond funds in the U.S. holding Puerto Rican debt, reports The Associated Press. Larger holders include Oppenheimer Funds and Franklin Resources, according to Barron's. If you are concerned about exposure, it's best to check your funds' holdings and determine whether it's time to rejigger your investments.
Do Puerto Rico's problems represent an investment opportunity? Every crisis is also an opportunity, right? The yields on some Puerto Rican bonds have risen, reflecting the higher risk that investors must take on when buying them. But investment publication Barron's warns that those higher yields may not be worth the risk, especially given the complicated nature of Puerto Rico's status as a commonwealth and what might end up being a difficult debt restructuring.
What's next for Puerto Rico? While it's unclear whether Garcia will succeed in convincing bondholders to postpone payment, the report from Kreuger offers several long-term recommendations to help rebuild the island's economic and fiscal structures, such as changing regulations to spur business growth and to get more Puerto Ricans working, higher taxes, and cuts in government spending.
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