By Thais DelaCuba

The Puerto Rico Bond Crisis has had a large impact on the United States’ almost $4 trillion municipal-debt market, which includes bonds issued by states and other local authorities as well as by cities. As a result of the sinking market, Puerto Rico’s current debt is between $52 billion and $70 billion, which is the third largest in the United States, only behind California and New York.  This amount of debt is alarming because Puerto Rico has a much smaller and poorer population compared to other heavily indebted states. Indeed, according to the Economist, the average state debt to personal income ratio is 3.4% in the United States, whereas Moody’s rating agency puts Puerto Rico’s tax-supported debt at 89%.

The current financial instability of Puerto Rico may have a grave effect on many smalltime investors around the United States. This is because U.S. mutual funds are heavily invested in Puerto Rican bonds due to a special tax exemption, which allows Puerto Rican bonds to be triple tax-exempt. In short, this means that bondholders do not pay federal, state, and local taxes for their coupon interest from the bonds. According to Morningstar, as a result of this exemption, around 70% of U.S. mutual funds own Puerto Rico securities.

The special tax exemption – which was intended to bring investors and business onto the island – has ultimately created the financial crisis occurring in Puerto Rico today. The financial crisis began in 2006 when a federal tax break for corporate income expired, which prompted many businesses to leave. Subsequently, unemployment on the island increased drastically and Puerto Rico began borrow funds to avoid further deficit. Finally, in February 2014, all three major ratings agencies downgraded Puerto Rico’s debt to below investment grade, widely referred to as ”junk” status. This indicates a greater risk of possible default or a debt restructuring. For U.S. investors, this means that the crisis in Puerto Rico will have a severe impact – not only on Wall Street, but also on thousands of everyday investors.