While the media and investors are focused on Greece, Puerto Rico is having a debt meltdown of its own. The U.S. territory owes lenders over $70 billion, $5.4 billion of which is due in the next 12 months. But without some form of debt restructuring, says Governor Alejandro García Padilla, it will be unable to meet its obligations. Countless municipal bond fund investors—many of them unaware they have exposure to the Caribbean island—could be affected.

Year-to-date, Puerto Rican munis have lost 9 percent while U.S. munis have gained 0.4 percent.

Puerto Rican Debt Sinks
click to enlarge

Our Near-Term Tax Free Fund (NEARX) has no exposure to Puerto Rico. NEARX invests predominantly in high-quality munis, and our investment team prudently adjusted fund allocations when it became clear the commonwealth would face serious problems paying back bondholders.

The same can’t be said for many other funds in the U.S., however. Over 20 percent of American bond funds owns Puerto Rico’s bad debt, according to Morningstar. Sixteen of the 20 mutual funds with the highest ownership by percentage are run by a single investment management firm. The same firm owns nearly half of all Puerto Rican debt that’s owed by U.S. funds. Another firm offers a fund that has half of its investments in Puerto Rican bonds.

You might be wondering why these funds have invested so heavily in the island. Because they carry a “junk” rating, Puerto Rican bonds offer a higher yield than more conservative bonds. They also provide what’s called “triple tax exemption,” meaning they’re tax-free at the federal, state and local levels.

The tradeoff, of course, is that investor assume a greater deal of credit risk. That’s why it’s crucial for investors to be familiar with their funds’ holdings.

To Bail Out or Not to Bail Out?

On Monday, Governor Padilla asked Congress to grant Puerto Rico the ability to declare bankruptcy. The problem, though, is that like all U.S. states, the territory can’t file for Chapter 9 bankruptcy protection. That’s an option available only to municipalities and cities such as Detroit, whose own bankruptcy exactly two years ago was the largest in U.S. history by debt, estimated at between $18 and $20 billion.

Whether to bail out the commonwealth is currently being debated. Some officials believe Puerto Rico is “too big to fail.” Others argue that its leaders haven’t done enough to reverse years of economic slowdown. Forty-six percent of all native-born Puerto Ricans who moved to the U.S. mainland between 2006 and 2013 did so for job-related reasons, according to the Pew Research Center.

“Puerto Rico is a beautiful island with a rich culture, but currently its government isn’t doing enough to encourage young professionals to stay,” says Kat, USGI’s web designer, who moved from Puerto Rico to San Antonio in 2007. “The cost of living keeps going higher while wages haven’t improved. I don’t know what needs to be done, but raising the sales tax and doing nothing to prevent talent from leaving the island aren’t the answer.”

Highly-Rated Municipal Bonds Remained a Relatively Safe Asset Class

Just as investors should know what assets they own, it’s important for them to realize that Chapter 9 filings—at least among highly-rated municipalities—have been the exception, not the norm. According to ratings agency Moody’s, Baa-rated munis historically had similar default rates as Aaa-rated corporate bonds.

Average Cumulative Default Rates, Municipals vs. Corporates: 1970-2013
10-Year Period
Ratings Corporate Municipal
Aaa 0.49% 0.00%
Aa 0.99% 0.01%
A 2.73% 0.05%
Baa 4.61% 0.32%
Ba 19.27% 3.53%
B 40.48% 15.14%
Caa-C 66.02% 14.64%

Again, NEARX invests in quality, short-term munis. Having provided investors with over 20 straight years of positive returns, the fund holds five stars overall from Morningstar, among 184 Municipal National Short-Term funds as of 6/30/2015, based on risk-adjusted return.

Let’s hope our friends to the south can reach a solution to the debt crisis.


© U.S. Global Investors

© U.S. Global Investors

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