A Puerto Rican flag flies from a building.
Photograph by Joe Raedle — Getty Images
By Reuters and Fortune Editors
August 4, 2015

Puerto Rico has defaulted on debt by paying only a fraction of what was due Aug. 1, showing the depth of the island’s economic and cashflow problems and potentially opening the door to broader defaults and litigation from bondholders.

The U.S. commonwealth paid only $628,000 of a $58 million payment due on its Public Finance Corp (PFC) bonds, the head of its Government Development Bank said in a statement on Monday.

“Due to the lack of appropriated funds for this fiscal year, the entirety of the PFC payment was not made today,” GDB head Melba Acosta said.

Puerto Rico Governor Alejandro Garcia Padilla shocked investors in June when he said the island’s debt, totaling $72 billion, was unpayable and required restructuring. The non-payment marks the first default by the commonwealth and is the most notable since Detroit defaulted on $1.45 billion of insured pension bonds before filing for bankruptcy in 2013. (Read more about the background to Puerto Rico’s debt crisis here.)

 

“(They are) telling investors they are serious about this debt adjustment,” said Peter Hayes, head of asset manager BlackRock’s Municipal Bonds Group, which does not own any commonwealth-backed debt. “It may be a precursor to how they make payments going forward if they can’t reach amicable settlements with creditors groups.”

A default could open the door to a fight with investors. Daniel Hanson, analyst at Height Securities, said in a research note last week that market participants would probably file a lawsuit in San Juan as soon as Tuesday. The Wall Street Journal reported that a group of Puerto Rico policy makers is working on a restructuring plan and should present it by the end of August.

According to Thomson Reuters data, holders of PFC debt include OppenheimerFunds, Franklin Templeton and Lord Abbett.

“We will vigorously defend the terms of the bond indentures,” a spokesperson for OppenheimerFunds said in a statement.

“I’m not mad, I’m not surprised,” said Ben Eiler, managing partner of First Southern Securities, ahead of Puerto Rico’s announcement. “They’re making a strategic default, and they’re prioritizing payments, and so they’re going to do the ones that are less important first, and that’s going to … strongly influence bondholders to negotiate,” said Eiler, who personally holds PFC bonds.

While Puerto Rico has argued that missing a payment would not constitute default because its legislature is not legally bound to appropriate the funds for payment, credit agencies and investors saw it differently.

“Moody’s views this event as a default,” said Moody’s analyst Emily Raimes in a statement. “This is a first in what we believe will be broad defaults on commonwealth debt.”

Standard & Poor’s said the missed payment presages other possible defaults as liquidity becomes further constrained, and added it would impede the island’s ability to obtain financing for cash flow needs. The credit agency lowered its rating on $1 billion of PFC debt following the default to “D” from “CC”.

PFC bonds have weaker protections than many other Puerto Rico bonds such as general obligation debt.

Also on Monday, Puerto Rico said in a regulatory filing it had temporarily suspended making monthly deposits to its general obligation redemption fund.

The decision to skip the debt payment showed the commonwealth was prioritizing its citizens over creditors, investors said.

Acosta said the decision reflected “serious concerns about the Commonwealth’s liquidity in combination with the balance of obligations to our creditors and the equally important obligations to the people of Puerto Rico.”

“A government’s primary responsibility is to provide services to citizens,” said Blackrock’s Hayes. “When you finally make the determination not to pay, you know you’re effectively cutting yourself off from the capital markets, but from their standpoint they see it better of two evils.”

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