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Feeling the Heat From Puerto Rico

The commonwealth's fiscal and bond-market woes have dealt pain on mutual funds.

Eric Jacobson, 10/17/2013

Puerto Rico has struggled with financial problems for a while. Things began deteriorating even before the 2008 financial crisis, thanks in part to a 2006 tax-benefit expiration and the resultant exodus of manufacturers from the island, according to Morningstar municipal credit analyst Candice Lee. The commonwealth's difficulties have only worsened since then, with well-documented strains such as a crumbling infrastructure, high crime, and unemployment all coming up against a contracting economy and weak tax revenue. 

In the Penalty Box
Although Puerto Rico's bonds bounced back strongly after the financial crisis according to Barclays data, investors began to penalize them more severely in 2012, when, as a group, their returns were less than half that of national muni benchmarks. After the broader bond market began to sell off in May 2013, however, Puerto Rico's fortunes began to slip from bad to worse. Detroit's bankruptcy filing naturally spooked investors, who began looking around to see which might be the next shoe to drop. Negative headlines and new data about the commonwealth's fiscal challenges didn't help matters. Its bond yields had already blown out to an average of 6.8% by the end of September 2013--some individual issues fared much worse--when Standard & Poor's lowered its outlook on bonds issued by the island's Sales Tax Financing Corp. (COFINA). The U.S. government shutdown that began on Oct. 1 only added insult to injury given that Puerto Rico relies on federal funding for an unusually large percentage of its own government spending. From the start of May through Oct. 1, 2013, Barclays' Puerto Rico Index tumbled 18.7%. That compares with a 4.4% loss for the broader Barclays Municipal Bond index.

Where Did Those Bonds Come From?
Many investors might assume they're immune to those troubles by virtue of living on the U.S. mainland. Those who hold their own state's funds might think they're even more insulated than investors with national fund exposure. Unfortunately, the pain has been more widespread than many might guess.

The debt of Puerto Rico has historically found its way into a considerable number of mutual funds thanks to a crucial tax advantage possessed by the commonwealth. Owing to its status as a U.S. territory, the island's municipal debt is not only exempt from federal taxes, but state and local levies, as well. That makes it unusually attractive to fund managers, and in particular those who run portfolios invested in narrow, single-state markets with limited and illiquid issuance. In recent years, meanwhile, the relatively high yields offered by Puerto Rico bonds have been extremely enticing to those whose fund sales rely most heavily on the competitiveness of their distribution rates.

A Broad Footprint
In fact, there are approximately 180 funds in Morningstar's database--representing more than $100 billion in net assets--that boast weightings of 5% or more in Puerto Rico bonds. Of course, there is a wide variety of issues and issuers in Puerto Rico with different levels of perceived safety, so not every fund has suffered proportionately, but there has been something of a throw-the-baby-out-with-the-bathwater effect in play. At the same time, the island's latest troubles have happened concurrently with the broader market sell-off, so not every unit of loss can be attributed to the former. Ultimately, the damage among funds with heavy Puerto Rico weightings has been painful, and a number of large funds have been caught up in the carnage.

Among the largest funds with at least 5% exposure to Puerto Rico, there are some trends that show up almost regardless of how you slice and dice the data. There are 10 Franklin funds on the list, for example, and while one of them is explicitly marketed as a high-yield muni offering, the others are all single-state-focused portfolios. Oppenheimer occupies a prominent spot as well, with seven entrants.

Managers at the various firms represented on the list have different approaches, of course, and that can extend to what kinds of bonds they favor, even within Puerto Rico itself. Although it hasn't been as much of an issue during the market's latest turbulence, the Franklin fund complex tends to keep very light exposure, if any, to bonds backed by the tobacco industry's Master Settlement Agreement. On the other hand, several Oppenheimer portfolios are more heavily invested in that sector. Generally, though, both firms have emphasized subsectors of the Puerto Rico market that are considered to be more reliable. Those include the island's general-obligation bonds and those backed by COFINA, for example.

Holding the Bag
Puerto Rico's troubles have more badly hurt a subset of funds with especially high weightings in the commonwealth, however. The largest exposure of all belongs to Franklin Double Tax-Free Income FPRTX, which is designed to serve investors who want to avoid their own state's taxes and otherwise wouldn't enjoy a tax benefit from holding their own state's bonds. (Some states, such as Illinois, tax the income from many of their own bonds.) Even though the portfolio holds reasonably large stakes in higher-quality issuers within the commonwealth--including a nearly 15% stake in bonds with third-party insurance--its more than 60% exposure to Puerto Rico puts the fund squarely in the midst of the storm. The fund tumbled a harrowing 15.7% from May 1 through Oct. 1, 2013.

A look at the rest of the funds among the top-20 holders of Puerto Rico debt shows a gut-wrenching trend for investors in the Oppenheimer municipal funds complex. In all, Morningstar counts 20 municipal funds managed by the firm, with an average loss of roughly 8.9% over the May 1 through Oct. 1 period. The most fortunate investors in the group have been shareholders in the firm's offerings that focus on short- or intermediate-term bonds. Oppenheimer has run its municipal funds with a very strong focus on income production for many years, and while that has resulted in very generous yields, it has provided plenty of volatility. Although they all bounced back strongly in 2009, for example, the average return among the firm's 18 funds in existence during 2008 was a stomach-churning negative 32.2%. Notably, however, most of those funds did not suffer especially damaging redemptions at the time.

Breathing Room
If there's one question that's likely on the minds of Puerto Rico investors, it's "What now?" Muni funds overall saw more than $6.5 billion in redemptions in September, with at least $500 million coming out of the 20 funds with the greatest exposure to the commonwealth. At a minimum, that has put pressure on managers who might otherwise be content to ride out the storm.

Many of the funds with large exposure to the island's bonds continued to suffer losses in the first calendar week of October, as the Barclays Puerto Rico index tumbled another 3.6% from the 2nd through the 9th of the month, and it seems the bad news is just feeding off of itself. There have been press reports that Puerto Rico has been having a difficult time selling new bonds to market and that it has been falling back on private placement and bank financing.

Normally, that kind of liquidity trouble might be cause for panic, but there are rays of hope. For one thing, consensus in the investment industry appears to be that the commonwealth's more structurally defensive issues still deserve relatively high investment-grade ratings, an opinion shared by Morningstar's own municipal credit analysts. Perhaps as important is a point recently made by T. Rowe Price's head of municipal fixed income, Hugh McGuirk, to USA Today. He noted that Puerto Rico has fairly little short-term debt, and therefore a muted risk that failure to get financing will trigger a crisis in the near future.

Eric Jacobson is Morningstar's director of fixed-income research and an editorial director for mutual fund content.

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