Puerto Rico Grabs a Big Hammer, Last Tool in Its Box

It wasn't supposed to get this far, though the possibility grew as talks dragged on. The legal cudgel that lawmakers gave Puerto Rico last year was expected to force creditors to come to some out-of-court agreement. It was meant to be the last option that was so onerous to bondholders that it would force them to the negotiating table despite the more than a dozen debt issuances with competing claims on the island's revenues. Going to federal court was only supposed to happen after Puerto Rico failed to reach an agreement after it engaged in good faith efforts. There were certainly negotiations, although the sincerity of those intentions is open to debate. And now, just days after Puerto Rico lost temporary immunity to lawsuits, the island took out the hammer.

Puerto Rico has signaled that it plans a one-and-done approach to bankruptcy, according to Sean McCarthy, head of the municipal credit research team at Pacific Investment Management Co. That means the island and its overseeing judge will try to shrink the total amount of debt enough so that it has some reasonable chance of thriving afterward.

Already, Puerto Rico bondholders have started to realize that the fiscal board put in place by Congress to oversee the island's finances isn't particularly friendly to their desires. Indeed, this board budgeted just $404 million toward servicing the island's debt in the 2018 fiscal year, compared with $3.3 billion of scheduled payments, according to Municipal Market Analytics analyst Matt Fabian.

The full certified 10-year fiscal plan is draconian toward debt investors. And any judge overseeing the restructuring proceedings will consider these financial assumptions as a starting point for when the oversight board reconfigures Puerto Rico's obligations, McCarthy said.

At some point, even as some hedge funds and others hunker down for a long, expensive battle, some investors will decide they want out and will try to sell their bonds. This is especially the case for some debt that has stopped generating regular coupon payments, making it expensive to hold. That's when creditors will start to find out how much it hurts to get smacked by a hammer.

— Read More in Debt Than Puerto Rico, the Virgin Islands Rejects Rescue on ThinkAdvisor.