The legal framework for state failure (as opposed to municipal failure) is uncertain; no state has defaulted on its debt since Arkansas in 1933. In an article titled “Legal Uncertainty and Municipal Bond Yields: Market Spillovers from Puerto Rico”, prepared for the 2019 Municipal Finance Conference in Brookings, Chuck Boyer of l The University of Chicago Booth School of Business argues that the markets view Puerto Rico’s recent failure as a precedent for the legal framework in the event of a US state failure. (In the United States, city and county governments can declare bankruptcy; states cannot.) Using an event-study methodology, Boyer finds that government bond prices have had statistically significant reactions to legislation and legal decisions regarding Puerto Rico. By reducing the legal uncertainty surrounding a possible state default, Puerto Rico’s decisions reduced the cost of government borrowing, he finds.
Boyer’s studies highlight four events in the Puerto Rican saga. First, in 2014, Puerto Rico enacted the Puerto Rico Public Corporation Debt Enforcement and Collection Act (Collection Act), which allows crown corporations to restructure their debts. Two years later, in 2016, they passed the Debt Moratorium and Financial Recovery Act (Debt Act) which allowed Puerto Rico to stop repaying its debt. Third, the same year the US Congress passed PROMESA, allowing Puerto Rico to restructure its debts on more favorable terms to creditors than Chapter 9, the means by which local governments declare bankruptcy. Finally, in 2018, a judge ruled that Puerto Rico’s special tax bond payments were optional during bankruptcy proceedings. These events “lessen market uncertainty as they have begun to set a precedent for a state government default framework,” Boyer writes.
Using data on individual state government bonds, the author estimates changes in average bond spreads between state bonds and U.S. Treasury debt of similar maturities, 15 days and 30 days. days after the announcement of each event. Bond spreads are a measure of the market’s judgment about a security’s risk level. Boyer explains that “if an event results in an increase in the expected collection rate, one would expect to see a decrease in the spread, as the expected payment to creditors is now higher.” By controlling for factors related to the characteristics of each bond, Boyer finds that the three laws reduced the bond spread to between 0.03 and 0.08 percentage point. In addition, consistent with its assumption, the ruling that Puerto Rico does not need to pay its tax obligations in bankruptcy, which lowers the collection rate, increased the rate spreads by 0.08 percentage points. . These results suggest that government bond prices reacted to legal events in Puerto Rico.
The author also examines whether states with poor fiscal health are more affected by court rulings in Puerto Rico, as they are more likely to default. He finds mixed results for this hypothesis. Although government bonds with credit ratings lower than the highest investment rating reacted negatively to the Recovery Act, increasing spreads between 0.95 and 1.25 percentage points, neither the Debt Act nor PROMESA had no significant or significant effect. He concludes that there is no general evidence that weaker state governments are particularly affected, but suggests that a model of legal uncertainty might better inform responses.
In short, Boyer finds that court rulings on Puerto Rico are narrowing the bond spreads between government bonds and Treasury debt. This suggests that one channel affecting municipal debt is legal insecurity. The author concedes that more research needs to be done on the legal uncertainty channel, but says his findings imply that establishing a legal framework for state government default could lead to lower costs of borrowing for state governments.