PAC Pacific Current Group Ltd

Puerto Rico's debt crisis moved into a more treacherous phase for residents, lawmakers and bondholders Monday, with the expected default by the Government Development Bank on a $422 million payment.

The likely missed payment, the largest so far by the island, is widely viewed on Wall Street as foreshadowing additional defaults this summer, when more than $2 billion in bills are due.

Together with the spread of the dangerous Zika virus, the risk of cascading defaults is putting new urgency on delicate bipartisan negotiations in Washington over legislation granting new powers to restructure more than $70 billion in debt issued by the territory.

Treasury Secretary Jacob Lew warned on Monday that a U.S. "taxpayer-funded bailout may become the only legislative course available" if Congress doesn't approve the proposed restructuring legislation. The warning came in a letter sent to Congress.

The island's debt is held by mutual funds, hedge funds, bond insurers and individual investors, who were attracted in part by tax benefits and high yields. Any GDB default Monday would cast serious doubt on the commonwealth's ability to make other future payments, which "means that other defaults are very likely on other Puerto Rico credits," said Paul Mansour of the investment management firm Conning.

The government will make a $22 million interest payment due Monday, a GDB spokeswoman said, but it will likely miss a $367 million principal payment. The government earlier swapped $33 million worth of debt coming due Monday for new debt with later maturities, the spokeswoman said.

A provisional deal announced Monday with hedge funds holding about $900 million of GDB bonds shows the complex lengths that Puerto Rico's leaders must go to as they wait for Congress to establish a legal framework for a broader restructuring. Under the proposed swap, bondholders would swap into new GDB bonds worth about 57% of their original claims, but would exchange that debt yet again, and take a bigger haircut, if the island achieves a global restructuring

Monday's developments amount to the latest sign that a long-running economic crisis has reached an acute stage, embroiling financial markets and the U.S. political process. Benchmark Puerto Rican bond prices fell to near record lows Monday, with some investors paying less than 65 cents on the dollar for general obligation bonds maturing in 2035. Just two years ago, investors snapped up $3.5 billion of those bonds, which carry an interest rate of 8%. Prices dropped below 64 cents on the dollar only once, when Puerto Rico passed a law last month allowing the suspension of debt payments.

While Monday's default had been expected, the missed payment creates new headaches for the local government. Its agencies maintain their bank accounts at the GDB, which serves as the government's fiscal agent and financial adviser and backs loans to private enterprises, so the default could trigger litigation to freeze those accounts. The government had already passed legislation to limit withdrawals from the agency to avoid a potential bank run, and the commonwealth's treasurer last month began opening accounts at private banks.

Puerto Rican Gov. Alejandro Garcí a Padilla had said in a televised address Sunday that the island was struggling to pay for such basic goods as fuel for police cars.

"We simply don't have enough money to pay for all these services and pay our creditors," he said.

The default could also mark a turning point after weeks of negotiations on Capitol Hill. House Republicans are completing legislation to create a federal oversight board with the power to sign off on local budgets and to authorize a court-supervised debt restructuring. The bill wouldn't commit U.S. taxpayer funds, but some creditors have described it as a bailout because they say it might violate existing contracts.

House Speaker Paul Ryan (R., Wis.) has forcefully rallied Republicans to back the legislation, the product of unusually bipartisan discussions with the Treasury Department. Mr. Ryan is warning colleagues that, if the local government can't manage the crisis, calls for actual taxpayer assistance will mount.

"The longer this goes on, the more likely there will have to be a federal bailout," said Marc Joffe, a former senior director at Moody's Investors Service who is now principal consultant at Public Sector Credit Solution, a research group.

Mr. Garcí a Padilla hasn't said what he would do if Congress doesn't agree on legislation. He denounced a multimillion-dollar lobbying effort against the bill, backed by various creditors, as a "brutal campaign of racial discrimination and lies," and he said failure by Congress to address the crisis "could become a public embarrassment for the United States."

Puerto Rico, whose residents are U.S. citizens, has been mired in recession for a decade and borrowed heavily to balance budgets. Despite the shaky economy, investors snapped up its debt for years thanks to generous tax incentives. The borrowing spree, however, did little to create economic opportunity on the island, and residents have steadily left for employment on the U.S. mainland, eroding Puerto Rico's tax base.

More recently, the Zika virus is threatening to strain the island's public health infrastructure while damaging its tourist sector. The Centers for Disease Control and Prevention reported last week the first U.S. death related to the Zika virus, that of a Puerto Rican man in his 70s who died in late February.

Puerto Rico's debt crisis isn't seen as likely to spill into the U.S. economy or the broader $3.7 trillion municipal bond market because the island's unique set of economic troubles make it something of an outlier.

Congress is considering legislation because the commonwealth's public institutions don't have access to federal bankruptcy courts, unlike municipalities in U.S. states. Because Puerto Rico isn't a country, it can't turn to the International Monetary Fund for assistance.

Despite weeks of close negotiations, the Treasury hasn't blessed the bill. Officials say restructuring provisions can't allow creditors to drag their feet in any workout. Conservative Republicans, meanwhile, are seeking assurances that the legislation wouldn't set a precedent for distressed states, for example, to write down debt in order to shore up public pensions.

The battle in Congress boils down to one about leverage. Treasury and Puerto Rico want a process that makes it easier to restructure debts because this will give the island's financial advisers more leverage in negotiations with bondholders. Creditors want one that makes it impossible to restructure debts or void contracts because this preserves their leverage.

Mr. Ryan is caught in the middle. As bondholder advocates lobby against the bill, he risks losing Republicans. This would force him to choose whether to push through a bill with predominantly Democratic support.

Treasury says a broad restructuring regime is needed in part to avoid litigation between creditors who hold debt with differing security pledges and who are likely to sue each other to make claims on the island's dwindling revenues. Creditor battles, officials say, could prolong the debt crisis for years and chill private investment in Puerto Rico.

Meantime, bondholders have accused the local government of refusing to negotiate in good faith and, together with the Obama administration, of exaggerating the crisis in order to compel federal legislation.

Last year, the island made several debt payments only after taking emergency measures, such as withholding tax refunds and delaying payments to local contractors.

Write to Nick Timiraos at nick.timiraos@wsj.com, Heather Gillers at heather.gillers@wsj.com and Matt Wirz at matthieu.wirz@wsj.com

(END) Dow Jones Newswires

May 02, 2016 16:35 ET (20:35 GMT)

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