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Athens on the Caribbean: Puerto Rico’s Lessons

While the Greek debt mess unfolds half a world away, another debt mess is looming much closer to home in the unincorporated dependent U.S. territory of Puerto Rico.

I use that vague description for the Commonwealth, which lies between the Dominican Republic and the Virgin Islands, because since we acquired the island in 1898 as a result of our victory in the Spanish-American War, we still can’t figure out what to do with it.

What, Exactly, is Puerto Rico?

Puerto Rico’s squishy legal status as not-quite-a-state-but-still-part-of-the-U.S. seemed to be acceptable as long as nobody but tourists paid much attention to the island. But now that the Commonwealth owes $72 billion and can’t pay back its creditors, concern about San Juan extends beyond hotel rates on Condado Beach. Since Puerto Rico isn’t a state, and therefore falls outside the umbrella of U.S. municipal bankruptcy law, the question is how the U.S. legal and financial system will cope with what could be the bankruptcy of Puerto Rico. Click here to see a list of Puerto Rico municipal bonds trading history.

The question is more than merely academic. Because interest on Puerto Rico’s debt is exempt from federal taxation, and from taxation by any state or local municipality in the U.S., Puerto Rican bonds became the financial version of a universal donor. Like O negative blood, which a person of any other blood type can receive in a transfusion, Puerto Rican bonds can go into the portfolio of any municipal bond mutual fund and still keep the fund double or triple tax-exempt. For high-tax states like New York, Massachusetts and California, the tax-exempt returns from municipal bond funds are very appealing, so being able to add Puerto Rican bonds to the in-state bond mix in state-specific muni bond funds made them very attractive. And that made issuing debt very easy for the Puerto Rican government.

Lesson #1: No Free Lunch

Of course, the impending Puerto Rican mess involves bonds and interest payments, not stocks and dividends. But the long run-up to today’s problems can be very illuminating.

First, when anything involving investments seems almost too good to be true, watch out. In an era of low interest rates, yield-hungry investors gobbled up higher-paying Puerto Rican bonds, which paid those higher rates because Puerto Rico’s economy is significantly smaller and poorer than most states and/or counties and cities and is a riskier credit.

In stocks, too, you rarely get something for nothing. When stocks pay extraordinarily high dividends, check to see where the money is coming from. Sometimes, investors are getting their own capital back in the form of dividends. In the case of real estate investment trusts and business development companies (which I wrote about a few weeks ago here), which have to pay out 90% of their income as dividends, make sure you understand the companies’ financials so that you can be sure they aren’t playing legal, but imprudent, financial games to meet payout requirements.

Lesson #2: Finance is Fashion

If you equate Wall Street and investing with seriousness, rationality and concern for investors’ long-term success, sit down and brace yourself: the Street and the fund industry are all about selling you whatever is in fashion. Want to buy tech stocks? Wall Street will (and did) create tech companies whose shares you can buy. Don’t ask what those companies do or whether they’ll ever turn a dime’s profit. People demanded tech stocks and Wall Street obliged.

The sensible people who like the sensible stocks that pay dividends usually don’t have to worry about Wall Street’s ceaseless sales efforts. But watch out when dividends become popular, which they are now. Wall Street will find a way to take an honest meat-and-potatoes dividend and turn it into a boeuf au gratin concoction, like a rider on a variable annuity, or some futures- or debt-linked vehicle that sounds great on paper – and feeds into the current frenzy – but undoubtedly costs a fortune and usually backfires once investors latch on to some other theme.

Less #3: Debt Covers Up Real Problems

Whenever borrowing takes place to permit a continuation of consumption that otherwise would not be sustainable — think Puerto Rico, Greece, many states that have to meet pension obligations, U.S. homeowners who took on huge mortgages — watch out. Debt is the narcotic that tricks you into thinking you’re OK when you’re really not.

The Bottom Line

We should be worrying about our nation’s huge visible debt, as well as the invisible unfunded obligations that we will owe aging baby boomers through Social Security and Medicare. But that’s a story for another day. For dividend investors, just keep an eagle eye open for the debt of the companies cutting those dividend checks. If they’re loading up on debt, even at today’s cheap rates, watch out.

Correction From Our Dividend Advisor

We apologize for an error in the original version of our Dividend Advisor which stated that Disney (DIS) had decreased it’s dividend. In fact, it did not, it switched from paying an annual dividend of $1.15 per year to paying $0.66 semi-annually. The $1.32 ($0.66 × 2) vs. $1.15 results in a 15% increase to this stalwart’s dividend. See all of Disney’s dividend data here.

Evan Cooper, is an award-winning financial journalist. After reporting on business at The Miami Herald, Evan worked on Wall Street at the New York Stock Exchange, the Securities Industry Association and Drexel Burnham Lambert. He was Editor-in-Chief of On Wall Street, a publication for financial advisors, research editor of Institutional Investor, and Deputy Editor of InvestmentNews, where he was honored by the Society of American Business Editors and Writers with a “Best in Business” award for his online opinion column.