The answer may surprise you.
For many of us, Puerto Rico probably conjures images of sun and fun, and perhaps a visit on a cruise ship. The U.S. territory doesn't look quite the same, though, when viewed through the lens of municipal-bond holders. Although its yield-rich bonds have been popular among investors, the Commonwealth has become notorious in recent years for its poor fiscal health. Its problems are many, and, as noted by Morningstar municipal credit analyst Candice Lee, they include an overburdened pension system whose funding levels are by far the lowest in any U.S. state or territory, and whose largest plan is currently projected to run out of funds by 2018.
The territory's overall budget situation doesn't look any better. In addition to its pension weakness, the Commonwealth continues to run budget deficits and suffers from very high annual debt service requirements. It's not as though the local government has stood idly by. There have been some improvements in recent years, including pension and tax-reform efforts. Lee notes that they haven't pushed the needle very far, though, given that the territory's economy has deteriorated, while its debt service--and borrowing to meet budget gaps--has grown. According to data collected by NewOak Capital Advisors, Puerto Rico ranks ahead of every U.S. state in terms of debt/GDP and debt/revenue ratios. That firm has also taken a stab at evaluating the pricing of the Commonwealth's debt and figures that its 30-year bond yields would need to exceed at least 6.5%--well ahead of their recent 5.4% mark--in order to be attractive.
In Your Own Backyard?
Puerto Rico's problems might seem a world away, but bonds issued by the territory sometimes find themselves in places you wouldn't expect. Unlike most other municipal debt, the income from most Puerto Rico bonds isn't taxable at the federal, state, or local level for most U.S. investors. Combined with their rich yields, that feature makes bond issues of the Commonwealth particularly appealing to fund managers who have trouble finding enough bonds, or enough income, on their usual stomping grounds.
Indeed, the list of funds with large exposures to Puerto Rico, is long--more than 70 funds in Morningstar's database boast at least a 10% exposure to debt issued by the Commonwealth. That list, meanwhile, is dominated by a number of single state muni offerings serving investors in states such as Wisconsin and New York. Of the top 20 funds in Morningstar's database with the most exposure to Puerto Rico, only two have a national mandate.
There are a few ways to look at this phenomenon. The most charitable explanation is that managers invest in Puerto Rico when they can't find enough opportunities in the local state market. Most fund managers don't want to purchase bonds at just any price, so if a portfolio has more cash than it can put to work in its own state's debt market--keeping in mind that most bonds are bought at issue and tucked away in investor portfolios--it makes sense to seek out bonds from somewhere else, such as a U.S. territory, that will still deliver income without a tax liability.
And while Puerto Rico's finances are clearly troubled, it's definitely possible that some managers do their homework and decide that the payouts on the territory's bonds are sufficient compensation for their risks. Some try to insulate themselves from bigger trouble, meanwhile, by sticking with bonds tied to the revenues of specific projects or essential services. Most of the Oppenheimer funds with large Puerto Rico weightings, for example, focus on electric utilities, highways, and higher education.
A Yield in Sheep's Clothing
A more cynical reading of the situation would suggest that some managers sprinkle Puerto Rico issuance into their portfolios simply to boost yield. With agency ratings in the BBB range, the debt of Puerto Rico is technically investment-grade but tends to trade alongside the issuance of high-yield muni sectors, with fat payouts relative to higher-quality debt. As of Oct. 5, 2012, for example, the subset of Puerto Rico bonds tracked by Barclays carried a yield of roughly 3.9%, while the broader national index was paying out 2.2%. Moreover, a comparison of Morningstar yield data versus fund exposures to Puerto Rico shows a strong correlation between the two, such that funds with larger exposures to the Commonwealth are likely to be among the market's higher-yielding portfolios.