#-ad_banner-#Although the city of Detroit’s $18 billion bankruptcy declaration in 2013 was taken in stride by the stock market, bond insurance companies lost billions and saw their stocks slide in subsequent month.

This time around, Puerto Rico’s current financial struggles might not be so easily digested by the markets. The island’s $72 billion debt burden is so vast that the  governor says it is “just not payable.” In response, investors are fleeing shares of the municipal bond insurers, with losses exceeding 35% for one of the stocks.  

Yet demand for insurance in the $3.6 trillion municipal bond market won’t be drying up, and the recent selloff maybe a buying opportunity, at least for investors that can handle higher volatility and wait for the best of breed to emerge stronger.

Bond Apocalypse
Puerto Rico’s woes come as no surprise. The popular tax haven collects no capital gains tax and levies only a 4% tax on its residents’ income. Nearly a decade of economic stagnation has precipitated an historic migration of residents to the United States mainland. A third of those born in Puerto Rico now live on the mainland, and the island is suffering a brain drain on its workforce.

The solution up until now: issue more debt. Investor demand for debt issued by the island was strong for its triple tax exemption from federal, state and local taxes. Sluggish economic growth meant the island couldn’t retire debt but, with rates below 6%, it could always just issue new debt to cover the old.

That is, until credit rating downgrades and other municipal defaults started scaring investors in 2013. Puerto Rico saw the yield on its new issues jump to 9% for general obligations bonds and to 15% for bonds issued by the Puerto Rico Electric Power Authority (PREPA).  

As far as Washington is concerned, no bailout will be forthcoming. (Nor was there a bailout for Detroit’s bondholders.) So current bondholders will need to make concessions, something the island government has already suggested.

The island’s political status as a commonwealth does not allow it to file for bankruptcy as is allowed for individual states. A bill in Congress that would allow municipalities and public entities to declare bankruptcy is unlikely to pass since a bankruptcy would amount to a federal bailout.

This is where the municipal bond insurers come in. More than a quarter (28%) of the island’s debt is insured, which may severely deplete their capital bases.

One Insurer Survives The Fallout
Shares of bond insurers are getting hammered with Assured Guaranty Ltd. (NYSE: AGO) down 17%, MBIA, Inc. (NYSE: MBI) down 39% and Ambac Financial Group, Inc. (Nasdaq: AMBC) down nearly 29% in just the past few weeks.

The total amount of Puerto Rican exposure at the three insurers topped $11.8 billion at the end of 2014. Ambac Financial and MBIA’s exposure is greater than their statutory capital. Statutory capital is the amount of liquid assets required to cover insurance exposure and stay in business.

An eventual agreement with creditors will determine the true extent of these firms’ exposure. The city of Detroit reached a settlement that saw bond insurers pay about $0.26 on the dollar for insured bonds. A similar settlement for Puerto Rico would still mean billions in losses, but could actually leave one insurer in a stronger position.

The relatively smaller exposure as a percentage of capital at Assured Guaranty should mean that it can weather the process of a Puerto Rican restructuring. Since insurers’ profits depend heavily on their credit rating and the cost they pay for debt, emerging from the situation relatively unscathed could see the company’s rating upgrade, which would lower the firm’s own cost of capital and lead to higher levels of profitability.

Thanks to the recent pullback, shares of Assured Guaranty trades for just 0.6 times book value against a five-year average of 0.8 times book. The shares are likely to see more pressure as the Puerto Rican debt restructuring story develops, but investors may want to start strategically buying into a position. The shares pay a 1.9% yield and could be worth nearly $30 on any sign that the company will avoid a major fallout from the Puerto Rican debt crisis.

Risks To Consider: Even relatively healthy Assured Guaranty could see further weakness as the story of Puerto Rico’s default develops. Long-term investors should stagger their position to take advantage of potentially lower prices without trying to time a bottom.

Action To Take –> Take advantage of a sell off in Assured Guaranty on the imminent restructuring of Puerto Rico’s debt to buy a long-term position in the shares.

Just because Puerto Rico might be a mess right now, doesn’t mean you should ignore other investing opportunities abroad. High-Yield International is your best source for investing trends, opportunities and sky-high yields abroad. In fact, 75% of the world’s highest-yielding stocks are overseas. For more information about international investing, click here.