Governor Alejandro Garcia Padilla of Puerto Rico. (Photo: AP)

Puerto Rico is poised to default on about $400 million worth of Government Development Bank debt as of the close of trading on Monday, marking the third time in less than a year that the U.S. territory has missed a debt payment. But as dramatic as that news is for the island, it’s having little impact on the broader U.S. muni market, whose assets total $3.7 trillion.

“What’s happening in Puerto Rico is staying in Puerto Rico,” says Matt Fabian, partner at Municipal Market Analytics, an independent research firm. At least for now.

That’s because many institutional investors and mutual funds have sold much of their holdings and those still holding Puerto Rican debt have had some expectation of default.

John Miller, co-head of fixed income at Nuveen Asset Management, told Bloomberg Radio on Monday that because of the deteriorating economic situation in Puerto Rico his firm has reduced its Puerto Rican holdings to near zero, and any remaining Puerto Rican bonds it owns are insured.

But not all mutual funds have unloaded their Puerto Rican debt holdings. The  Franklin Double Tax-Free Income Fund and several Oppenheimer municipal bond funds still hold large percentages of assets in Puerto Rican muni bonds. 

“What we’re really worried about now is economic decline actually accelerating because in part the Government Development Bank is impaired,” said Miller. And that could increase the odds that Puerto Rico defaults on $2 billion worth of general obligation debt due July 1. 

Puerto Rico’s economy is in bad shape, having endured a recession for almost 10 years. The island has an unemployment rate near 12% — more than twice the rate for the U.S. – and has been losing population for the past five years. At the same time it has $70 billion in debt, more than any U.S. state except New York and California.

Puerto Rico doesn’t have “the revenues to meet all its budgetary expenses and pay debt services at the same time,” said Miller.

Indeed, Puerto Rico Governor Alejandro Garcia Padilla, in a speech Sunday night announcing Monday’s expected default,  said, “Faced with the inability to meet the demands of our creditors and the needs of our people, I had to make a choice.”  Last month he signed an emergency bill, passed by the Legislature, that allows the Puerto Rican government to halt payments on its debt.

The island would have preferred to have the ability to declare bankruptcy under Chapter 9 in order to restructure its debt, as cities have, but it has no legal access to bankruptcy under federal law.

The House Committee on Natural Resources has been working on a bill that would create a federal oversight board over Puerto Rico’s finances, which could help the island reduce debt in a bankruptcy-like federal court proceeding, but that bill, supported by House Speaker Paul Ryan (R-Wis.), lingers in committee, and the House is not in session this week. If Congress fails to act before July 1 and Puerto Rico defaults on the $2 billion worth of GO debt, the impact could be dramatic not only because of the size of the default but also because of the role that general obligation bonds play in the muni market. They are supposed to be backed by the full faith and credit of the issuer.

A default on those bonds would push the default rate of the entire muni market from about 0.5% of outstanding bonds to 2%, which “would be a radical change from where it’s been,” says Fabian.

He recommends that municipal bond investors stick with higher quality, higher coupon debt over lower quality, higher yield debt. Yields spreads between higher and lower rated bonds are tight, which means investors are not being adequately compensated for the additional risk, explains Fabian. “If you’re only giving up 30 to 40 basis points to buy safer credit long term, why not buy that?”

Jordan Niefeld, a financial advisor with Raymond James & Associates in Aventura, Florida, doesn’t expect  today’s default on Puerto Rican bonds will “upend the municipal bond market” but he suggests that any retail investors holding them “seek other alternatives.”

 — Related on ThinkAdvisor: