This is part 8 of the Bermuda Investment Primer series.

Bonds are not equity in a company, municipality, city, state, or country. Bonds are good old-fashioned debt.

Most bonds are issued with a term-certain maturity date (shelf-life if you will) at which time, you as an investor owning one bond (or more) should receive 100 per cent of the principal back; the amount stated on the electronics coupon (say, $1,000) regardless of whether you paid less than, or more than the principal amount at original purchase.

What happens if the bonds you purchased from the bond issuer aren’t paid back? Read on.

This is the story of the island of Puerto Rico, its government, its economy, and its bonds.

Currently, Puerto Rico has $123 billion in outstanding debt, spread between bonds and unfunded pension liabilities, representing more than 68 per cent of its Gross Domestic Product.

According to Bloomberg BusinessWeek, US District Judge Laura Taylor Swain said: “Failure is not an option. We cannot turn off all the lights and close the door on Puerto Rico.”

“The way forward will involve a lot of pain.”

See “Puerto Rico Debt Case Starts With Squabble Among Bondholders” by Steven Church, May 12, 2017 (goo.gl/Ep5yDo).

Bonds, bonds, bonds: high-grade bonds are supposed to be more conservative, safer than stocks, particularly if the issuers are considered sovereigns: US, Canada, United Kingdom, Germany, Australia, Norway, Switzerland, Japan, and others — generally, the strongest and most solvent global nations. Implicit security, high credit ratings, stability and backing of the countries’ governments mean that these bond interest rates are low (or even negative), but bondholders know they will get their full principal investment back.

However, bonds are not always high-grade, even though they may begin their verifiable journey as such. Why? Because the fiscal health of the nation determines financial success; that is, its underlying economy must produce sufficient surplus funds each year to service the debt.

At the end of the day, if a country, corporation, fund, municipality, etc cannot cover the repayment of borrowings to bondholders, then, fierce renegotiation of principal repayments begin, bankruptcy / insolvency / bond defaults may be declared, credit ratings are severely downgraded, and investors, large and small, are dumped into loss positions. I would opine that small investors are hurt more in these manoeuvres simply because they may not have the financial resources to ever recover from such a hit.

Puerto Rico, probably the best known for its amazing national baseball talent, is a Caribbean island with a population of 4.3 million, with a long history of connections to the United States. https://en.wikipedia.org/wiki/Puerto_Rico

In 1917, the Jones-Shaforth Act, enacted by President Woodrow Wilson, gave the people of Puerto Rico US citizenship as well as exempting them from US federal income taxes; US tax credit incentives were granted to US business operations locating on the island.

Further, the interest payments on bonds issued by the Puerto Rican government and its subdivisions were also exempt from not only US federal, but state and local taxation as well. This meant these bonds resembled US municipal bonds that also claim “triple-tax exemption”, and a willing investor participation soon arose to the island’s benefit.

While the country appeared prosperous, albeit with assistance of these continuing US government subsidies, cloudy local Puerto Rican governmental accounting, mismanagement, inability to efficiently correlate all the civil service accountability and disparate functions, the operations of the 78 municipalities, deficiencies in reporting systems and fiscal oversight, finally led to an economy, that after 1973 was continually in an annual deficit.

Puerto Rico then began to issue bonds each year, just to balance the budget — then repeated this cash contribution from sale of the bonds annually for more than 40 years.

Sinking deeper and deeper in non-repayment of debt mode, Puerto Rico even issued new bonds to pay off old bond debt, along with refinancing cheap interest rate debt under less desirable higher interest rates, the opposite of what good investment managers would do.

Then, after many years of complacence, the chickens came home to roost.

Finance specialists suggest that the debt may never be repaid. The island economy has shrunk, 12 years into a recession, a 45 per cent poverty level and more than 13 per cent unemployment rate. Austerity measures of all sorts are either in place, or contemplated. To add to the distress of such a staggering debt, an estimated 30 per cent of bondholders are Puerto Rican.

So what happened to this country?

What was the original credit rating on these bonds? Were they considered high-grade?

Currently, these bonds are at junk status. See the link to my previous article below, The good, the bad, and the truly junk for comparison.

Was any detailed research conducted on the Puerto Rico government capacity to repay?

Who sold these bonds to the US and international public investors? Who invested in these bonds: pension funds, institutional finance managers, etc?

How on earth did the Puerto Rico governments, politicians, administrators think they could pay this massive debt back?

Careful conservative fiscal policies are an absolute must for any country. In great contrast, the Bermuda Government has issued debt to foreign investors, a significant amount for its size and percentage per capita.

We are, through very determined fiscal conservatism, pulling our government finances back to balanced budgets with a longer-term plan to repay every single penny we have borrowed.

Next week: there are great lessons to be learnt from the Puerto Rico crisis. They are not allowed to file bankruptcy, but it is one — just known by any other name!

Sources: Wikipedia, the Puerto Rican government-debt crisis https://en.wikipedia.org/wiki/Puerto_Rican_government-debt_crisis

Prior articles on understanding bonds for the Bermuda Investment Primer series in The Royal Gazette, Moneywise column written by Martha Myron.

Bonds, bootstraps and bottomless pits, March 3, 2012, https://goo.gl/lUSceQ

Risk and reward — make careful bond choices, October 22, 2016, https://goo.gl/qWiL6t

Bonds: the good, the bad and the truly junk, October 15, 2016, https://goo.gl/80NEjm

Junk bonds and the tale of the Trump haircut, October 08, 2016, https://goo.gl/ycwSnV

Martha Harris Myron CPA PFS JSM: Masters of Law, International Tax and Financial Services. Pondstraddler Life™, financial perspectives for Bermuda islanders with multinational families and international connections on the Great Atlantic Pond. Contact: martha@pondstraddler.com