Deja vu all over again?

Markets were down big yesterday over fears of the long anticipated "Grexit" of Greece from the European Union and bad news from Puerto Rico.

Greece is seeking another bailout for its debt obligations, has limited bank withdrawals, and faces a 6pm deadline this evening for a $1.7 billion debt payment to the IMF. There is no "grace period" according to IMF rules. Due to the threat of impending default, the European Central Bank has limited emergency funding and Greece's government has imposed a variety of capital controls.

The way the finances are structured, if Greece defaults on the IMF debt, other creditors can demand accelerated payments and penalties that would force Greece into default on those debts as well. This would cause a collapse of the Greek economy and financial system. However, it is unlikely that other creditors would undertake this action, as it would lessen the likelihood of them recovering their assets.

But, that threat of debt acceleration is the "stick" creditors are using to the threaten the Greek government into meeting their nation's IMF obligations.

In addition, financial problems in Puerto Rico have also come to a head as the island is unable to repay more than $70 billion in municipal bonds. The island has offered investors bonds over the past few years which were almost irresistible for one reason, their relatively higher yields. In some cases, bonds in 2014 offered a return of 8.7%. Of course, that premium was part of a risk-reward equation in which investors were supposed to realize that Puerto Rico is NOT the US government, and thus this pay out would be subject to some additional uncertainties.

It seems that many did not heed this warning, and jumped into Puerto Rican bonds in a big way. The Wall Street Journal reports that more than half of US municipal-bond funds are invested in Puerto Rico. Funds from Oppenheimer and Franklin Templeton hold almost 10% of Puerto Rican municipal debt while financial giants like Wells Fargo and Eaton Vance also have many funds who have invested in the island.

This bad news led to the market sell off yesterday, as the two situations once more reminded investors that our interdependent world means that a sneeze in one nation can lead to a cold across the globe. Markets in the US declined with the SP500 approaching its trendline support at the 200-day SMA. The Dow has done likewise. As of this writing, stocks are flat-to-up slightly from the open, but have not recovered the lost ground from yesterday's sell off.

We have had quite a ride with equities, but investors, burned by the financial crisis of 2008, remain wary of bad news that could have unforeseen impacts. Surely bankers learned their lessons and have not made a series of terrible/interconnected bets on Greece? Surely the "insurance" of their credit-default swaps will work as advertised this time? How can Greece, which is hardly an Olympian on the world economic stage, take down the stock market in the US?

On the other hand, the optimists note that a "Grexit" might actually pay benefits in the long run for both the people of Greece and investors in the US. The Greeks could, if they left the European Union, eliminate the harsh austerity measures imposed by the IMF and other creditors. One also wonders if perhaps world-economic turmoil might cause the US Central Bank to once more adjust it's rate-hike plans and leave the party going for equities yet a bit longer. Afterall, the Greek crisis has been going on for more than five years at this point. How can bankers not be prepared?

Puerto Rico's mess, of course, is a relative newcomer. But there is a lot of room there to deal with the situation. The island has not really cut back on spending yet, they have assets which could be sold to raise cash, etc. In short, the austerians holding the bonds will demand their pound of flesh before they will accept any haircut on their promised tax-free yields.

We will wait and see with both of these situations. On the face of it, they should not reignite the chaos of a few years ago. But, they do provide all investors of an important lesson. Again, there is no free lunch. If all bonds are paying 2-3% and you find some promising 7-8%, this is because of additional risk. Ignorance is no excuse when it comes to higher-risk investments.

And when markets get overheated--as demonstrated by our most recent Valuation Warning, this is a time to be wary of a move to the downside and prepare for a sell of by taking profits and/or hedging against the possibility.

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