Puerto Rico darkening cloud over muni investments

Sunny Puerto Rico is casting some of the darkest shadows on investment portfolios this winter.
The Caribbean U.S. territory with great beaches and extensive financial problems is now perilously close to default, an outcome with the potential to further damage an already weak municipal bond market.
Puerto Rico has approximately $70 billion in outstanding debt that has remained a popular investment – due to being exempt from local, state and federal taxes – even as the island economy has stagnated for close to a decade.
About three-quarters of municipal-bond mutual funds include at least some Puerto Rico bonds, according to Morningstar Inc., meaning many businesses and individual investors have felt the impact as those bonds have lost 20 percent of their value this year.
Puerto Rico bonds are currently rated at the lowest possible investment grade and on Dec. 12 Moody’s Investors Services placed the island on review for a downgrade to junk status.
In Massachusetts, problems in Puerto Rico have prompted an investigation from Secretary of the Commonwealth William F. Galvin into whether three firms – Fidelity Investments, Oppenheimer Funds and UBS Financial Services – adequately warned customers of the risks associated with Puerto Rican bonds in their mutual funds.
According to Reuters, nearly 17 percent of the assets in the $69 million Oppenheimer Rochester Massachusetts Municipal Fund, a single-state fund open only to Bay State residents, are made of up of Puerto Rico debt.
So how will fiscal crisis in Puerto Rico impact Rhode Island?
The good news is that, unlike Massachusetts, the only mutual fund exclusively for Rhode Island residents, the $227 million Aquila Narragansett Tax-Free Income Fund, does not hold any Puerto Rico bonds.
Rhode Island has not taken such an active role in financial regulation, partly because fewer firms are based here, and R.I. Secretary of State A. Ralph Mollis is not currently looking at following Galvin’s example, according to spokeswoman Raina Smith.
Still, many investors hold national mutual funds that do include Puerto Rico bonds, and the value of municipal bonds in general could be depressed more by a Puerto Rico default than Detroit’s recent bankruptcy.
“Since Puerto Rico is such a prominent issuer of munis, with its bonds so widely held, the trouble there is believed to be a factor in causing the entire municipal-bond market to trade with higher yields than it would otherwise,” Robert E. Cusack, portfolio manager at Whalerock Point Partners LLC in Providence, said in an email. Even with public-sector pension concessions, the island’s reliance on short-term borrowing for government operating expenses does not appear sustainable.
The territory is legally prohibited from filing for bankruptcy protection, so many observers expect a debt restructuring with unclear impacts for the broader bond market.
“2013 was obviously a difficult year for bonds generally and municipals specifically, the likes of which we have not seen since 2008,” wrote Morgan Stanley Wealth Management Managing Director John M. Dillon and Vice President Matthew Gastall in the firm’s municipal-bond year in review Dec. 5.
Dillon and Gastall said they expect the credit ratings of municipal issuers to improve along with the broader economy, “despite select legacy credit challenges for certain high-profile issuers such as Detroit, Puerto Rico and a handful of others.”
Cusack at Whalerock advises investors still in the municipal market to hold tight for now.
“At the moment, the market for these bonds is thin and volatile, with the same issue trading with swings of as much as 15 points in the same day,” Cusack wrote.
One positive for Rhode Island and most states is that they traditionally have not invested significant pension-system assets in municipal bonds, because they do not benefit from the tax advantages like private investors.
The Rhode Island state pension system does not have any “direct” investments in Puerto Rico bonds, according to Joy Fox, spokeswoman for General Treasurer Gina M. Raimondo.
Fox would not say, however, whether any of the pension system’s hedge funds are invested in Puerto Rico bonds, because hedge funds do not publicly disclose their investments.
In November, the last month available, the pension fund’s equity hedge funds returned 2.1 percent and real-return hedge funds 1.2 percent, while its traditional fixed-income investments lost 0.3 percent. Domestic stocks gained 2.9 percent.
Under Raimondo the state pension system has begun investing 15 percent of its $8 billion in assets toward hedge funds, a source of controversy because of their high fees and opacity. •

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