Puerto Rico faces a moment of truth on Tuesday, as the island owes a $355 million payment - a possible default which could trigger lawsuits, further spook investors and undermine the island's efforts to climb out of $72 billion in debt.
The payment on bonds issued by the U.S. commonwealth's financing arm, the Government Development Bank (GDB), are crucial as Puerto Rico tries to stretch its liquidity into 2016 to give itself more time to restructure debt. A default is seen as possible but not definite.
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With 45 percent of its 3.5 million population in poverty, Puerto Rico is a meteorological paradise mired in economic purgatory. Years of over-spending and the expiration of corporate tax incentives stuck it with debt that gets harder to pay as residents increasingly emigrate to the U.S.
Governor Alejandro Garcia Padilla wants to overhaul spending and restructure debt, but bondholders are resisting cuts to repayments, and restructuring discussions look to take months.
Of the payment owed on Tuesday, $273 million is protected by Puerto Rico's constitution - so-called general obligation, or GO, debt - so defaulting would likely trigger lawsuits.
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Even a default on the non-GO portion could result in litigation against the GDB. "Of course" creditors would sue, said one creditor-side source. "It would be really messy."
Lawsuits could hinder the island's ongoing efforts to get creditors to cooperate on a universal bond exchange, or "superbond," that would reduce its overall debt.
Puerto Rico has defaulted before, in August paying only $628,000 of a $58 million payment due on its Public Finance Corp bonds.
But a default on GO debt would have a bigger market impact, given its constitutional protections.
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"There would be a new round of selling pressure," said John Miller, co-head of fixed income for Nuveen Asset Management. If Puerto Rico defaults on debt guaranteed by the commonwealth, the chance of it making another GO bond payment due on Jan. 1 "would drop precipitously," Miller added.
A default could also hinder public services. Daniel Hanson, a Height Securities analyst closely following Puerto Rico, said in a Nov. 25 note that a default could put GDB into receivership, which would "almost certainly result ... in a stay" on its ability to move cash and, in turn, on the government's ability to support operations.
Moody's Investment Service last month said it was "likely" Puerto Rico would default on at least some of the debt, and Garcia Padilla has said that if forced to choose between paying debt and providing services, Puerto Rico would default.
Lately, though, "there's been a change in tone" on the government's part, said the creditor-side source. Puerto Rican officials are aware that a default could risk creditors' cooperation on the superbond, and are likely to make the December and January payments to keep talks alive, said the source, as well as another person familiar with discussions.
Garcia Padilla will also speak on Tuesday at a U.S. Senate Judiciary Committee hearing to discuss potential fixes for Puerto Rico.
(Reporting by Nick Brown; Editing by Bernard Orr)