Nearly two dozen municipal bond funds have 10% or more of their assets in Puerto Rican muni bonds, according to Morningstar, the mutual fund trackers (see chart). Oppenheimer Rochester Virginia Municipal fund, for example, has a third of its portfolio in Puerto Rico bonds.
Franklin Double Tax-Free Income, has 65% of its assets in Puerto Rican bonds. The fund began life in 1985 as Franklin Puerto Rico Tax-Free Income Fund and was launched to give state and federal tax-free income to residents of states that issued few muni bonds.
Puerto Rico has about $70 billion in municipal bond debt, and that debt has been extremely popular with mutual fund managers. The bonds are free from state and local taxes in all 50 states, and they have extremely high yields.
How high? Consider a bond backed by Puerto Rico's general taxing authority, slated to mature in July 2016. The bond currently yields about 5%, according to Bloomberg. In contrast, a U.S. Treasury note that matures in three years yields about 0.6%.
High yields mean high risk, however, and investor worries about Puerto Rico's finances are why yields are so high for the island's bonds. Moody's Investor Services rates Puerto Rico Baa3 with a negative outlook -- high enough to be considered investment grade, but right on the border of junk.
The biggest risk is default -- that is, that Puerto Rico won't be able to make timely interest or principal payments on its bonds, which are interest-bearing IOUs. Like states, Puerto Rico can't declare bankruptcy. But an entity can default without being in bankruptcy.
How risky are muni funds with lots of Puerto Rico exposure? Muni defaults are extremely rare, despite the high-profile collapse of Detroit earlier this year. Puerto Rico has taken several steps to shore up its financial condition, including revenue initiative! s that could raise $2.5 billion, says Moody's. The territory's economy is larger than 22 states, and its population is larger than 15 states.
But Puerto Rico's s debt continues to rise, and the United States is under no obligation to bail out its debt.
Money managers are divided about whether Puerto Rico's bonds are headed for harder times, or whether they're simply oversold by a nervous market. Manager Rafael Costas at Franklin thinks that the bonds are oversold. "While we feel Puerto Rico is facing a difficult situation, we feel that their bonds are being unjustly punished in the markets," he told shareholders in a recent letter. "They have taken significant steps to address their fiscal challenges and to raise revenues."
That may be. But in the meantime, shareholders in funds stuffed with Puerto Rico's bonds have suffered. Franklin Double Tax-Free income, for example, has fallen 13.2% this year, including reinvested interest. Oppenheimer Rochester Virginia Municipal fund is down 12.4%. That has to be a shock for investors who were looking for low volatility and tax-free income.