Christine Benz: Hi, I'm Christine Benz for Morningstar.com.
Debt crises in Greece and Puerto Rico have roiled markets recently. Joining me to discuss the potential implications for fundholders is Russ Kinnel, director of fund research for Morningstar.
Russ, thank you so much for being here.
Russ Kinnel: Good to be here.
Benz: Russ, let's talk about the Greek situation and its potential repercussions for mutual funds. Which categories are likely to be affected in some fashion? I wouldn't imagine there are many funds at this point that have heavy positions in Greek bonds, but I'm sure that there are some knock-on effects due to the crisis.
Kinnel: That's right. There are very few funds that have much in Greek debt or Greek equity. So, as you say, it's really a knock-on effect. I think there are two groups. One would be any fund with a lot of European exposure, whether that's equity or debt. Naturally there are some currency implications, but also the whole European Union is going through a bit of a crisis. Now, I think the positive is, everyone has seen this for years, so European banks and other institutions have had a long time to prepare for that, but of course, you can never really predict what the impact is going to be. I think a lot of people are still surprised it's actually come to this and that a Greek exit looks fairly likely today.
Benz: When you look across fund categories, I would imagine World Bond would certainly be affected. Those are the funds with fairly significant exposure to European debt. Europe stock as well. What are the other categories where investors might expect to see some volatility in the weeks and months ahead?
Kinnel: I would say foreign equities, in general, because even your standard foreign fund is going to be a majority in Europe. I think even emerging-markets debt, Greece, officially is … well, some people put them in emerging, some people put him in developed, but clearly whenever some kind of debt crisis happens, it often has an impact on emerging-markets bonds.
And we even heard that at the Morningstar Investment Conference: One of the things that some of the bond managers said looked the least attractive to them was emerging-markets bonds. So I guess they would say maybe now it's even less attractive.
Benz: So expect volatility in these categories, but don't necessarily upend your whole asset allocation plan?
Kinnel: That's right. I think a lot of areas were prepared for this. It is going to be volatile. Certainly we're going to see some knock-on effects that may be surprising, but I haven't changed anything in my portfolio. We heard at the conference a lot of managers talking about keeping some powder dry for buying opportunities, and I suppose to a degree investors could do that, too. So, maybe let cash built slightly with the idea that maybe some bargains will come up.
Benz: Let's shift over and talk about what's been going on in Puerto Rico. That situation, too, has been simmering for a while, but it appears to have come to full boil recently. That story has been a little bit less followed than the Greek situation. Let's catch people up on what's going on there.
Kinnel: Greece has $300 billion of debt that they can't pay. Puerto Rico has $90 billion in debt that they can't pay. It's about one-third the size, but there are some real problems there. Puerto Rico's debt is all muni debt, and Puerto Rico has said, they more or less acknowledge, what has been fairly apparent for a while that they can they can't pay off all of that debt. In turn that has spurred the selling of Puerto Rican munis, and so we're seeing significant declines this week.
Benz: Let's talk about the role of Puerto Rican bonds in municipal-bond funds. I think it might be surprising to some muni investors, the percentage allocations that certain funds have made to Puerto Rican bonds. Let's talk about how some funds are able to make such sizable bets on Puerto Rico.
Kinnel: That's right. If you have a California or a New York fund, you're probably thinking, well, clearly I don't have Puerto Rico, but in fact you might, because when the SEC came up with a name rule, and the name rule says if something is in the name then you've got to be at least 80% in that security. So, for instance, small caps or Europe or a lot of other things like that, you've got to be 80% in there.
But when they came out with that rule, the muni firms, and probably Puerto Rico, successfully lobbied the SEC to create an exemption saying a single-state muni fund can also invest in Puerto Rico because it's also free from taxes in that state. But to me it's really a disservice to investors because really the whole point of the name rule is to keep people from having those surprises, to keep funds from taking risks that people didn't expect, and that's exactly what happened here.
Benz: Especially in a tame category like municipal bonds, people didn't necessarily expect a lot of risk in their portfolios.
Kinnel: That's right. You might be in a state with a high credit rating and yet your fund has a significant amount of Puerto Rico exposure, which is really disappointing. You can probably see it. It's starting to show up in funds' returns. So if your fund is lagging its peer group significantly, it might be because of Puerto Rico.
Benz: The attraction in putting a big stake in Puerto Rico was that the yields were oftentimes significantly higher than what the state muni bonds might offer. But the drawbacks are on display right now.
Let's talk about some of the funds that have been hit the hardest by their big weightings in Puerto Rican bonds.
Kinnel: Essentially it's funds that have been the most aggressive at chasing yield are the ones that have done this, and in particular, Oppenheimer Rochester funds, which has long been maybe the most aggressive player out there in the fund world, have some very big stakes. Oppenheimer's Maryland Fund has about a 50% stake in Puerto Rico; that's as of end of May. Their Virginia Fund has a significant chunk; and even the New York and California funds have 10% or 20%. And in fact the worst-performing muni funds are largely Oppenheimer funds as well as Franklin has a Double Tax-Free Fund, which was a more or less all Puerto Rico, which is in the process of liquidating and those are all the worst performers for the year.
Now if you've got a Vanguard or Fidelity muni funds, you probably have nothing in Puerto Rico. It really illustrates the difference that they are very concerned with capital preservation and have a high-quality emphasis and Puerto Rico has been a long, growing problem. So a lot of the more quality-centric, more risk-averse firms have long been out of those munis.
Benz: So it's probably too late now for people who already own some of these Puerto Rican-laden muni bond funds, but it sounds like a message would be, if I see a yield that's substantially higher than maybe is the norm in a category, that should be a red flag, something at least that would get me digging about what's going on, what risks are being taken on in this portfolio?
Kinnel: That's right. And unfortunately there are still some people who buy funds based on their yield, and that's a really backward way to do it. Higher yield means higher risk, and it often is the case that even a little higher yield in the bond world comes with a lot more risk. So it's not just an incremental move up in yield means incremental move up in risk. And that's what's illustrated here.
In the bond world, credit risk is sneaky. It can lay dormant. For the last 10 years Puerto Rico barely started to hit. Another kind of credit risk in munis rarely hits, but when it does hit it can be a really big problem. So even just looking at the last say three or five years of returns does not necessarily tell you that there's added risk.
Benz: We have experienced some volatility across markets. Equity markets have not behaved well recently, and it seems like we could potentially be entering a period of higher volatility. It sounds like your messages are know what's in your portfolio. Also don't use the rearview mirror necessarily to drive the car. Any other takeaways for investors navigating what could be a volatile market for the rest of the summer?
Kinnel: I think these things are always hard to predict. You might have thought the problems in Greece would mean the euro would get killed versus the dollar, and it briefly sold off and then came right back, and I think that's right about where it was last week as we speak. So these things can be hard to predict. A lot of the equity markets have rebounded because they can be priced in.
I think diversification, caution, understanding your fund's risks and your overall portfolio risks will get you through these times. And generally it's worth remembering what Warren Buffett says about be greedy when others are fearful and fearful when others are greedy. This has been a time when most people have been greedy. But if we start to get where most people are fearful, some bargains might pop up.
Benz: Russ, thank you so much for being here to share your insights.
Kinnel: You're welcome.
Benz: Thanks for watching. I'm Christine Benz from Morningstar.com.