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A Puerto Rican default: Its effect on the municipal bond market

A Puerto Rican default: Its effect on the municipal bond market (Part 1 of 9)

Must-know market update: Is Puerto Rico losing its salsero vibe?

Puerto Rico, an unincorporated territory of the U.S., the island of breathtaking beaches which attracts many a travelers in search of tranquility and peace, doesn’t seem to be peaceful lately.

Puerto Rico's GDB Economic Activity IndexEnlarge GraphThe charm of the island has been over-shadowed with feelings of pessimism regarding the fiscally distressed state of the economy. The Puerto Rican government has been financing its deficits with bond issuances year after year, surmounting large amount of public debt, without paying much heed to accelerating the pace of revenue generation to meet the debt service obligations.

On February 4, 2014, S&P downgraded Puerto Rico’s general-obligation bonds to junk levels, making it even more difficult for the fiscally distressed island to borrow money and dig out from its severe fiscal problems.

One of Puerto Rico’s main industries is the government (non-productive), which employs at least 20% of the population. Industrial development in Puerto Rico is largely dependent on manufacturing, which accounts for close to 50% of its industrial revenue. It’s dominated by U.S. multinationals including pharmaceutical and medical device manufacturers. Some of the multinationals with significant assets in Puerto Rico are Johnson & Johnson (JNJ), Abbott (ABT), and Medtronic (MDT).

Much of this is attributable to the tax-exempt nature of the income that these multinationals can earn here. Even the bonds issued by the territory offer a tax-free income, which has led to their popularity in the U.S. The iShares National AMT-Free Muni Bond ETF (MUB), the State Street SPDR Barclays Short Term Municipal Bond ETF (SHM), and the Invesco PowerShares VRDO Tax Free Weekly Portfolio ETF (PVI), are few examples of such exchange-traded funds that have emerged as a consequence.

The downgrade has already initiated the flight of capital from the island. The government’s strategy to raise corporate taxes in order to bolster revenues might force the multinationals to leave, taking with them much-needed jobs to other countries. Although Puerto Rico still has US Pharmaceutical corporations operating on the island; it does not provide enough employment opportunities for the Puerto Ricans.

Pharmaceuticals, textiles, electronics, etc., have been the dominating manufacturing industries on the island over the years. The services industry which accounts for more than 25% of the industrial revenue, mainly comprises of tourism and the restaurant business. Considering the fact that the service and the government industries do not produce any goods as such for export markets, the economy is largely dependent on tourism and the U.S. multinationals for its foreign exchange revenue to provide for its deficits.

The Puerto Rican economy is in a state of massive fiscal debt, rising unemployment, low per capital income (half of that of Mississippi, which is the poorest state in the U.S.), high cost of living, and a drain of monetary and intellectual capital.

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