Puerto Rico’s proposal to raise $3 billion next month through a bond sale to keep the debt-addled Caribbean island afloat has led to questions over who will be first in line to get repaid in the event Puerto Rico runs out of money.

“As (Puerto Rican officials) secure up the new debt, they should respect the rights of the current existing bondholders because if they don’t they’ll lose credibility in the markets,” said James Spiotto, a bankruptcy attorney and managing director at Chicago-based Chapman Strategic Advisors.

Should Puerto Rico hit a financial wall down the road and find itself unable to pay off its considerable debts -- estimated at $70 billion -- it could create a scenario in which traditional bond fund investors who seek safety in the relative security of municipal bonds are pitted against so-called ‘alternative’ investors, or hedge funds that welcome risk because it can mean greater returns.

Consider that, according to Morningstar, nine of the top 10 bond funds with the largest exposure to Puerto Rico are managed by Oppenheimer Funds,  a large, well-known fund management firm subject to all federal disclosure and transparency requirements.

Municipal bond funds such as these are popular especially among retirees because they are considered among the safest investments, almost always providing a stream of steady and reliable returns. Puerto Rican bonds are popular in particular because the island’s status as a commonwealth, or U.S. protectorate, allows it to issue bonds whose interest payments are tax exempt in all 50 states.

Muni Bonds Tend to Attract the Risk Averse

In sum, municipal bonds backed by taxpayer dollars have traditionally been viewed as extremely safe and have therefore tended to attract the risk-averse.

But as Puerto Rico has slipped deeper into a financial abyss, the investment landscape for those seeking exposure to the island has become decidedly riskier. Earlier this month all three of the major ratings firms slashed the island’s credit to junk status, citing fears that a long-running recession, high unemployment, and rising expenses – notably in the form of soaring pensions costs for retired public employees – will make it difficult for Puerto Rico to raise money in the capital markets.

Analysts say the tax-exempt status that made Puerto Rican bonds so popular probably contributed to the island’s heavy debt load. Since the island’s bonds were so popular with investors it was easy for Puerto Rico to keep issuing them, allowing the commonwealth to bury itself deeper and deeper in debt.

“They had a very convenient outlet for raising cash and maybe they went to that well too often. They borrowed themselves into this problem,” said Robert Donahue, an analyst at research firm Municipal Market Advisors.

This is the difficult environment in which Puerto Rico now plans to raise $3 billion as sort of a  bridge loan to help it pay its debts and cover its expenses until a handful of recently approved financial reforms start to have a meaningful impact on the commonwealth’s budget.

And that’s why the proposed bond sale is expected to attract investors such as hedge funds  that actively seek risk as a means to larger returns. They are a very different breed than those seeking the safety of an Oppenheimer-managed bond fund.

Puerto Rico's Bonds Attracting 'Alternative' Investors

Spiotto said these "alternative" investors might even seek to leverage Puerto Rico’s desperation to negotiate terms favorable to them, terms that might include a provision that guaranteed them first-lien status with regard to Puerto Rican revenues earmarked to pay down debt, which would mean they would get paid first in the event the island began defaulting on its debts.

Meanwhile, all of this has undoubtedly raised concerns among current bondholders that the commonwealth’s ongoing fiscal troubles combined with $3 billion in additional debt obligations could crowd out revenue to pay existing investors.

A spokesman for Oppenheimer said the investment firm had no comment on the situation in Puerto Rico.

Spiotto said Puerto Rican officials will have to achieve a balancing act, convincing potential new investors that Puerto Rico is on the path to financial stability while easing concerns of existing bondholders worried about potential haircuts. To the latter, Spiotto said Puerto Rico must explain why this new round of financing will enhance the commonwealth’s ability to pay down its existing debt.

Hedge fund managers and other "alternative" investors are likely “scrubbing Puerto Rico’s” constitution to determine whether in the event of a default bond holders would get paid or revenue would be targeted first for public safety or other similar expenses such as infrastructure repairs, said Donahue, the municipal bond analyst.

These “very sophisticated” investors may also be looking to leverage their position to push Puerto Rican officials toward an accelerated program of financial reform, Donahue suggested. Provisions might include promises for a balanced budget by a certain date and full disclosure of all steps leading up to that goal.

“They’re watching very closely for any sign that this deal is going to impair them,” Donahue said.

Presumably so are Puerto Rico’s current bond holders.

Follow Dunstan Prial on Twitter @DunstanPrial