The unprecedented legal filing came only a few days after hedge funds and other holders of Puerto Rico’s general obligation debt thought they had cut a deal with the government to avoid bankruptcy.
The move represented one of the lowest points in Wall Street’s long, torturous history of investing in Puerto Rico’s bonds. The hedge funds have been battling to protect their investments through the administrations of two Puerto Rico governors and across Capitol Hill, keeping an army of lawyers, consultants and operatives gainfully employed.
“I don’t think anyone bargained for this,” said David D. Tawil, a co-founder of Maglan Capital, a New York hedge fund that had at one point invested in Puerto Rico’s debt. “I think most funds expected there would have been a consensual agreement by now.”
It does not take long to see why a solution to Puerto Rico’s debt problem has eluded the hedge funds and other investment firms that own the island’s bonds: Many of the creditors think they are, or should be, first in line for the money. But the island also has to keep paying its police officers and its teachers while it struggles to raise revenue.
Two bondholder groups in particular — owners of general-obligation bonds and owners of Cofina bonds, which are backed by sales tax revenue — are at odds. Each of those types of bonds, their investors argue, carries protections that put those bondholders at the top of the pecking order after a default.
Puerto Rico’s general-obligation bonds are backed by a provision in the island’s constitution that promises that if there is not enough money in the general fund for all planned expenditures, general-obligation bonds will be paid off before anything else.
That sounds good, but investors in the Cofinas say they have an even better claim because they have a dedicated repayment stream in sales tax revenue.
The money goes straight from the merchants to a trust — not to Puerto Rico’s treasury — so the government cannot lay claim to it and use it for anything else, such as paying the general-obligation bondholders.
With both the general obligation bondholders and the Cofina bondholders claiming dibs, it will very likely take a judge to force a resolution.
A law passed last summer under the Obama administration, called Promesa, was designed specifically to address Puerto Rico’s predicament. It created a bankruptcy-like process that the island and other United States territories could use to restructure their debts.
Bondholders fought vigorously on Capitol Hill to derail the legislation but lost. They did win a few concessions in the makeup of the fiscal oversight board that would oversee the government’s attempts to cut expenses. For instance, it would have to include three members from a list of people picked by Democrats and four picked by Republicans. That way, some bondholders figured, they could expect a more creditor-friendly approach.
But the bill that was finally enacted had many elements that could harm bondholders, including a “cramdown” provision, which gives a bankrupt government the power to force a deal on an unwilling creditor.
To investors — who bought the bonds assuming their legal protections were ironclad — it seems as though the governments in San Juan and Washington are constantly moving the goal posts.
Hector Negroni, co-chief executive of FCO Advisors, which is invested in Puerto Rico bonds, said the oversight board had failed to honor constitutional protections for bondholders and to carry out its duty to force the government to tighten spending.
The board’s actions, he said, are hurting not only bondholders, but also the people of Puerto Rico, because the island’s access to the debt markets would be indefinitely frozen.
“We were promised Promesa wouldn’t change the rules against creditors,” Mr. Negroni said. “Here we find ourselves with a board that has attempted to force a solution on us that does the exact opposite.”
Do not count the hedge funds out just yet. Puerto Rico may have veered from Wall Street’s preferred playbook, but some of these hedge funds employ skilled dealmakers and relentless litigators.
Those firms include Aurelius Capital, which was among the firms that fought Argentina in court for years over its sovereign debt default and succeeded in pressuring the government there to pay back its debt. But the legal issues may prove even more vexing in Puerto Rico.
The hedge funds are not the only investors in Puerto Rico’s $74 billion in bonds. Those bonds had been a staple of retirement funds across the United States, generating hefty yields for mom-and-pop investors at a time of low interest rates.
Those retirement funds had been assured that Puerto Rico had little choice but to honor its debts — even as the island’s pension costs swelled and its tax revenue ebbed. Mutual fund managers like Oppenheimer and Franklin Templeton are now fighting for repayment alongside the hedge funds.
It is too early to say whether the hedge funds will end up losing money on their investments, as they bought many of them at a discount.
Before the bankruptcy filing, general obligation bondholders were close to a deal with the government that would have valued their debt at 70 cents on the dollar, according to people briefed on the matter.
On Thursday, many of those bonds were trading around 66 cents on the dollar, according to Municipal Market Analytics.
Mr. Tawil of Maglan Capital said many investors had made the mistake of comparing Puerto Rico to an insolvent nation. But nations are typically bailed out by the International Monetary Fund before they collapse totally.
No such bailout has come for Puerto Rico. As a commonwealth of the United States, Puerto Rico does not qualify for I.M.F. assistance, and there was little appetite in Congress for a wholesale federal rescue. For months, investors and residents have been in a “five-ring circus,” as Mr. Tawil put it, where bondholders are fighting with the government, the control board and one another.
Even so, Mr. Tawil is considering investing in the debt again. “We are in this unknown territory,” he said. “How this all ends is unclear.”
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