In the 18 months since Hurricane Maria swept across Puerto Rico, the island has struggled to recover from the destruction left in its wake. The troubled power grid remains fragile, tarps still cover many homes, and tragic stories of storm-related deaths have re-ignited arguments over exactly what happened in the weeks following the Category 4 storm.

Yet even as Donald Trump and Puerto Rican governor Ricardo Rosselló have traded blame for the inadequate response, there’s another, less-noticed drama playing out over the territory—one with far-reaching consequences not just for how Puerto Rico can get back on its feet, but for the ability of cities and states across the United States to provide services for their residents as well.

Long before Maria ripped it apart physically, a financial storm devastated the Caribbean island. Faced with a collapsing economy, $72 billion in debt, and overwhelming pension liabilities, it was forced into bankruptcy in mid-2017.

Ever since, and especially after Maria, the island and its many creditors have been locked in nasty, sprawling fights over how much money it actually has and who it belongs to.

[This article was reported in partnership with WNYC as part of the series Puerto Rico: The Future of Debt.]

With tens of billions of dollars at stake, the bare-knuckles brawl has also roiled the massive municipal bond market back on the mainland. The fight over Puerto Rico’s debt raises questions about how safe it is to buy the bonds of other financially troubled cities and states such as Chicago, Connecticut, New Jersey, and Illinois.

Or as Adam Stern, co-head of research at bond market specialists Breckinridge Capital Advisors, puts it, what happens in Puerto Rico no longer stays in Puerto Rico.

The reason: municipal bonds finance two-thirds of all infrastructure across the US. Cities, states, and public agencies all turn to the “muni” market for funds to build schools, bridges, sewer systems, and much else besides.

The fallout from Puerto Rico’s bankruptcy threatens to make it harder, and costlier, to raise the money needed for such projects. Put simply, that means taxes could go up.

“If you give the government the ability to just cancel debt when it’s convenient, how will creditors find the confidence to lend to other municipalities in the future that might need debt to finance a new school building or a new road?” asks Dora Lee, director of research at Belle Haven Investments, which owns Puerto Rican bonds. “It would definitely lead to higher interest rates, and higher rates on municipal bonds means higher taxes for taxpayers who live in those municipalities.”

Coming on the heels of smaller, though no less painful, municipal bankruptcies in Detroit, Stockton, California, and Jefferson County, Alabama over the past decade, the impact is multiplied.

Last year, mutual fund giant Franklin Templeton announced it would no longer invest in bonds issued by Illinois, Chicago, or the city’s public schools. The firm had been among Puerto Rico’s largest bondholders before the territory defaulted. Its municipal bond group’s directors warned that the municipal bond market has undergone a dramatic shift, as borrowers have become far more willing to stiff their bondholders when they run into trouble than in the past.

What’s more, they believe more cities and states will have difficulty meeting their commitments in the years ahead. And when the choice comes down to funding public pensions, keeping up government services, or paying back bondholders, bondholders are increasingly likely to lose out. This shift has left many investors wary of the promises being made by municipalities under financial distress, or that could potentially become so.

“There are thousands of issuers in the market,” says Stern of Breckinridge Capital. “If an issuer starts to exhibit behavior you don’t like, there are usually plenty of other choices.”

Special cases

Nowhere have the risks raised by Puerto Rico’s financial troubles played out more than in a pair of disputes between some of the island’s biggest bondholders over what are known as “special revenue” bonds.

To understand why this matters, it helps to take a step back and look at the roots of Puerto Rico’s troubles. They began in earnest in 1996 when the US Congress phased out a tax break for manufacturers that set up on the island.

As Puerto Rico’s economy declined, tax revenues did too. Successive governments turned to Wall Street to stay afloat, and the bankers were only too happy to oblige. Financiers invented an ever more complicated array of special revenue bonds. Unlike general obligation bonds, which are paid out of general tax revenues, special revenue bonds are backed by specific pots of money.

Puerto Rico issued bonds for everything. Along with lots and lots of general obligation bonds, it created almost 20 types of special revenue bonds. It issued bonds backed by sales taxes, bonds backed by highway tolls, and bonds backed by water bills, gas taxes, and the rents on public buildings.

Puerto Rico even has bonds backed by rum sales.

This was not unique to the island. Stern estimates that special revenue bonds now make up around a third of the $3.8 trillion municipal bond market in the US. Investors like them because they are supposed to function like a lockbox: since the revenue stream is guaranteed, bondholders are protected from losses even if the borrower goes bankrupt.

As a result, special revenue bonds are considered safer than general obligation bonds. That means they’ve typically earned higher credit ratings and paid out lower interest rates. That’s why states and cities like them, too: they cost taxpayers less.

For governments with already weak financials, the difference can be substantial. Chicago’s general obligation bonds yielded around 4.2% on average over the past month, for example, versus the 3.3% yield on bonds backed by O’Hare airport revenues.

But Puerto Rico’s bankruptcy has raised questions about whether special revenue bonds are really as safe as investors thought.

“What we’ve found is that the promises that were made when times were good aren’t necessarily there when times are bad,” says Jane Ridley, a senior director at credit ratings agency Standard & Poor’s. “This is something we never would have expected.”

“Safer than Germany”

Puerto Rico sold roughly $13 billion in general obligation bonds and another $18 billion in bonds backed by the island’s sales tax revenues, known by their Spanish acronym, COFINA.

The revenue pledge, and the high credit ratings it garnered, was key to convincing investors to buy COFINAs even as the island’s economic troubles were becoming clear. In 2007, the first COFINA bonds received solid investment-grade ratings, just a year after a budget crisis shut the island’s government down for two weeks. In promoting the bonds, says Matt Fabian, a partner at Municipal Market Analytics, “they pitched Puerto Rico as being safer than Germany.”

Fast forward to 2016, and after Puerto Rico defaulted on its general obligation bonds, those bondholders sued to grab a share of the sales tax revenues. They claimed the money was rightfully theirs, since the Puerto Rican Constitution says that general obligation bonds must be paid first with “all available” resources.

Places like Chicago and New York state have issued sales tax bonds similar to Puerto Rico’s. Investors have feared that any outcome which undermines the COFINA’s iron-clad hold on the sales taxes could also upend long-held assumptions about many other bond offerings built around gas taxes, highway tolls, and other specific revenue streams.

This has been an “existential issue for the muni market,” says Peter Block, head of municipal credit strategy at Ramirez & Co. “Who owns this revenue?”

This has been an “existential issue for the muni market.”

After hard-fought negotiations, the judge overseeing the bankruptcy, US District Court Judge Laura Taylor Swain, recently approved a settlement in which both sides can claim victory, of sorts. While the COFINA bondholders will recoup much of their investment, their hold on the funds proved far less than iron-clad. In an exchange of the old debt for new bonds issued as part of the deal, senior COFINA bondholders were supposed to receive 93 cents on the dollar, while junior COFINA holders were offered just 56 cents for every dollar they invested. And when the new bonds were issued in mid-February, the swap was so poorly structured that many US-based retail investors found they got far less than they were promised.

The COFINA bondholders also agreed to give back $456 million in annual sales tax revenues to the government (nearly half of the yearly revenues that had initially been pledged), which can use the funds to pay the general obligation bondholders, among others. That was key to convincing the hedge funds gunning for the COFINAs to drop their lawsuit, and what has left investors questioning how safe other such structures will prove to be.

“People are now looking at these structures with a completely different set of optics,” says Jeffrey Lipton, the head of municipal research and strategy at investment bank Oppenheimer & Co. “Unless you are being appropriately compensated for the additional risk, there’s no reason to buy these bonds from weak issuers.”

And the dispute isn’t the only battle being fought over Puerto Rico’s special revenue bonds that poses heightened risks for the broader muni bond market.

Rocky road

A January 2018 ruling by Judge Swain addressing a different set of revenue bonds, which are backed by tolls collected by Puerto Rico’s Highways and Transportation Authority (HTA), has also raised big questions for investors.

Swain held that the HTA, which has $4.3 billion in outstanding debt, doesn’t have to make payments to its bondholders during the island’s bankruptcy. Her decision was a direct contradiction of earlier state court rulings that special revenue bonds have to keep paying out while proceedings are underway.

That obligation has been another reason why investors consider special revenue bonds safer than general obligation bonds. When municipalities default or go into bankruptcy, they typically stop making general obligation bond payments. The promise that revenue bonds will continue paying out gives them extra security. In theory.

Swain’s ruling undermined that principle in practice, raising further questions about the safety of special revenue bonds. “She’s modifying things that a lot of people have held as sacrosanct,” says Cate Long, who runs a research service for bondholders.

Reuters/Alvin Baez Puerto Rico’s financing arm, the Government Development Bank.

Swain’s decision is under appeal. Long, like many analysts, believe she got it wrong, and the dispute will likely be litigated all the way to the Supreme Court. Here, too, the impact will be felt well beyond Puerto Rico if the ruling is upheld, because the precedent could be applied to future municipal bankruptcies anywhere in the US.

“The danger is that if you put a cloud on special revenues, you’re only going to increase the borrowing costs for all the state and local governments,” says municipal finance expert James Spiotto, a managing director of Chapman Strategic Advisors.

How big could the impact be? The National Federation of Municipal Analysts (NFMA) warns that even cities and states with strong finances could pay an extra 5 to 10 basis points (0.05% to 0.1%) on their bonds. But the real hit will be to those in financial distress. They could see interest rates on special revenue bonds rise a full 30 to 50 basis points.

That may not sound like much, but with local governments expected to issue $75 billion in revenue bonds per year for infrastructure over the next decade, every basis point is meaningful, in absolute terms. Altogether, the NFMA estimates that borrowers could pay between $2 billion and $6 billion in additional interest if Swain’s ruling stands.

Those costs will be borne directly by the municipalities and states that issue the bonds, which ultimately means residents will pick up the tab in higher taxes, tolls, or user fees. Spiotto warns that the rising costs could lead some infrastructure projects to be delayed or cancelled, and in some cases, financially stressed municipalities could lose access to the bond market altogether.

With the COFINA settlement done and the HTA appeal playing out, focus over the coming months is expected to turn to sorting out Puerto Rico’s next big slug of outstanding debt: the general obligation bonds. In a move that’s sent a further chill through the market, in mid-January the federally appointed board managing the bankruptcy for Puerto Rico asked the court to invalidate more than $6 billion of the general obligation bonds issued in 2012 and 2014. The board argued that the bonds were issued in violation of Puerto Rico’s constitutional debt limits.

The move is widely seen as an attempt to increase leverage over the bondholders as the negotiations over that debt get serious, with little chance of succeeding. Were Judge Swain to allow it, that decision, too, would be appealed—given the sums involved, likely all the way to the Supreme Court.

Whatever the board’s motivation, one thing is certain: it has made investors even more cautious about the potential machinations hard-up municipalities are willing to engage in when the money runs low. “Trying to negate the legality of the issuance opens up a whole other can of worms that that isn’t good for anybody, especially for the municipal marketplace as a whole,” says Jonathan Mondillo, the head of municipal investments at Aberdeen Standard Investments, which owns general obligation and other Puerto Rican bonds. “If that doesn’t make you skeptical as a bond investor, I don’t know what does.”

And if all that wasn’t complicated enough, a recent Appeals Court decision has thrown another new wrench into the mix. Back in 2017, Aurelius, a hedge fund known for its aggressive tactics, filed suit arguing that Puerto Rico’s bankruptcy process itself violates the Constitution and should be thrown out, because the members of the federal oversight board were appointed by Barack Obama without Senate confirmation.

Judge Swain ruled against Aurelius last year, but in mid-February the Appeals court reversed her and sided with Aurelius. While the court left in place the COFINA deal and the many decisions the board has taken so far, it said Trump must properly appoint the current board or reconstitute it within 90 days. That will be tough in the current political climate, and in any case, the board has asked the Supreme Court to review the decision and put a hold on the 90-day deadline. The result will likely be further delays in sorting out a deal for the general obligation bonds, as well as for the many smaller slugs of debt that remain to be resolved.

Ratings scale

Even as the impact of Puerto Rico’s debt restructuring remains unclear, changes are coming to the muni market. Thanks to their perceived security, credit ratings agencies had treated special revenue bonds essentially as independent entities, often giving them significantly higher ratings than the general obligation bonds of the city or state that issued them. This practice is coming to an end, as the agencies move to link special revenue bond ratings much more closely to the underlying risk of the issuer.

In late 2017, for example, Chicago earned a high investment-grade rating of AA+ from Fitch Ratings on a $2.5 billion offering of sales tax bonds. That was fully seven notches higher than the city’s general obligation bonds, which were rated just above junk. In the wake of Swain’s HTA ruling, however, Fitch warned investors that it would modify its rating criteria. In May, it downgraded Chicago’s sales tax bonds a hefty five notches, bringing them more in line with the city’s overall rating.

Last fall, S&P, too, revised the criteria it uses to rate some 1,300 special revenue bonds. Now, revenue bonds will at most be rated one or two notches above the related general obligation debt, with rare exceptions.

This shift reflects the growing fear that cities or states that run into trouble will follow Puerto Rico’s lead and try to redirect pledged revenues, no matter the earlier guarantees.

“At some point you’re going to jettison your debtholders.”

“It goes to the fundamentals: if you’re a municipality you have to keep paying your police and fire and provide services,” says Alfred Medioli, senior credit officer for Moody’s, which has also revised its municipal criteria to account for the greater risks. “If you can’t pay those operations, at some point you’re going to jettison your debtholders.”

Ratings agencies have taken a lot of criticism, but their pronouncements still matter. Many investment firms have limits on how much lower-ranked debt they can hold. Lower ratings could force portfolio managers to sell certain bonds or demand higher rates from issuers to account for the increased risks.

That dynamic is already playing out for troubled issuers like Chicago, which was forced to pay higher rates for its issue of sales tax bonds than it likely would have paid before Puerto Rico’s troubles emerged. And despite the risks, plenty of investors ponied up for them, given the low interest rate environment of recent years. “Though investors are wary, there’s also a lot of money chasing higher yields and ignoring the lessons learned,” says Fabian of Municipal Market Analytics.

Will that change when the economy slows?

Stern of Breckinridge Capital argues that the US economy’s long expansion has reduced the pressure on fiscally troubled governments. “Right now, there’s probably a bit of a laissez faire attitude towards some of the weaker credits,” he says. “But when the tide goes out, market sentiment could turn on them much more quickly than people currently believe.”

When that happens, many municipalities will find themselves facing far tougher conditions, with far higher costs, when they seek to raise money to pay for projects. That will partly be due to broader economic trends and partly due to the fallout from the unique plight of Puerto Rico’s devastated economy.