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Losses on Puerto Rico Bonds Touch Some Distant Muni Funds

Losses on Puerto Rico Bonds Touch Some Distant Muni Funds

Posted by Juan Gavasa on July 22, 2014


Losses on Puerto Rico municipal bonds are weighing heavily on island residents who bought Puerto Rico-focused closed-end bond funds. Among them: retired Hall of Fame boxer Felix “Tito” Trinidad, who says his losses top $63 million.

But municipal-bond investors with no ties to the island also have exposure, through some nationally marketed and single-state muni-bond funds that put a significant chunk of their assets in Puerto Rico debt.

The 10 municipal-bond mutual funds with the highest percentage exposure to Puerto Rico bonds are offered by just two fund companies: OppenheimerFunds and Franklin Resources BEN -0.40%’ Franklin Templeton Investments, according to the most recent fund holdings tracked by data and research firm Morningstar.

The Franklin Double Tax-Free Income Fund recently had about 65% of its assets in Puerto Rico debt, the highest on Morningstar’s list. The next nine funds are from OppenheimerFunds’ Oppenheimer Rochester lineup, ranging from about 46% to 23% Puerto Rico debt.

Why do muni-bond funds designed for residents of states such as Maryland, Arizona and New York hold Puerto Rico bonds?  Like other muni bonds, the Puerto Rico issues pay interest that is exempt from federal taxation. Plus, U.S. territories like Puerto Rico, the U.S. Virgin Islands and American Samoa have the ability to issue bonds exempt from federal and state taxes in every state. By contrast, most muni-bond interest is exempt from both federal and state income taxes only if the investor lives in the state where the bonds were issued.

In some cases, fund managers may have looked to Puerto Rico debt for higher yields than they could get on muni issues in a particular state or to augment a limited supply of local debt.

The high percentage of Puerto Rico debt in some muni funds underscores the impact that financial difficulties in Puerto Rico—an island commonwealth with about 3.6 million people—can have on the larger $3.7 trillion U.S. municipal-bond market.

Puerto Rico bond prices have fallen in recent weeks after the government there signed off on a law that would allow Puerto Rico to restructure certain debts from its public corporations, like the power utility and highway authority. Any restructuring could lead to bondholder losses, prompting OppenheimerFunds, a unit of  Massachusetts Mutual Life Insurance, and Franklin Templeton to jointly file a lawsuit in U.S. federal court saying that the new law is unconstitutional.

The new law doesn’t apply to other Puerto Rico bonds, such as its general-obligation bonds or debt backed by sales taxes. Although passage of the new law “has eroded the market’s confidence in Puerto Rico’s ‘willingness to pay,’ we feel, given strong protective language in Puerto Rico’s Constitution, the possibility of a default by Puerto Rico’s general obligation bonds does not appear imminent,“ Franklin Templeton wrote in a blog post earlier this month.

In a statement, Franklin Templeton said the double-tax free fund was launched in 1985 to provide double-tax-free income—meaning interest exempt from both federal and state income taxes regardless of where the investor lived—to residents of states that issue relatively few bonds. Franklin Templeton noted the fund was closed to new investors as of August 2012.

OppenheimerFunds noted in a blog post this month that not all bonds that bear Puerto Rico’s name are directly tied to the island government, so its figures for direct Puerto Rico exposure are less than Morningstar’s data. For example, Morningstar says its Maryland fund has 46% of its assets invested in Puerto Rico bonds. Oppenheimer puts its true Puerto Rico exposure for that fund at closer to 35%.

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