For the past few weeks, Greece's flirtation with default has dominated the headlines – and for good reason. The danger to international markets is very real.

But for American income investors, a default closer to home could prove even more disastrous.

Should Puerto Rico default on $72-billion worth of municipal bond debt, it would hit U.S. income investors twice over. First, it would impact their holdings of the island's debt. Second, it would rattle other shaky municipal bond issuers.

On June 29, Puerto Rico's Governor, Alejandro Garcia Padilla, proposed that the country's creditors postpone interest payments “in order to invest in Puerto Rico.”

This caused bond prices to go into a tailspin – especially the $3.5-billion worth of 8% bonds due in 2035 that were issued just last year. After making scheduled payments on July 1, Puerto Rico is now in discussions with creditors under a forbearance pact that lasts until September 15.

Beyond that date, default seems more or less inevitable.

Yet unlike Greece, Puerto Rico didn't get into its current mess through spectacularly bad government. In fact, the island benefited for many years from an IRS provision titled “Section 936.” Under the provision, companies based in Puerto Rico were exempt from U.S. tax on their Puerto Rican income. However, Section 936 was terminated in 2006 – and the island has been in recession ever since.

Padilla's predecessor, Governor Luis Fortuño, even instituted spending cuts and tax increases, but people and businesses still emigrated in large numbers. That decimated Puerto Rico's tax base, and at this point, the sums simply don't add up.

Now, because Puerto Rico is a U.S territory, its debt is equivalent to U.S. municipal bonds. That means income from the bonds is free from federal income tax, which explains why Puerto Rican bonds are held by many income investors. However, that also means that Puerto Rico's $72-billion default would fall almost entirely on individual investors in the United States.