Puerto Rico debt roils U.S. municipal bond mutual funds

BOSTON, Sept 3 Tue Sep 3, 2013 11:55am EDT

BOSTON, Sept 3 (Reuters) - Nothing says Massachusetts like the John Hancock Massachusetts Tax-Free Income Fund.

But bonds issued by Puerto Rico account for 13 percent of the $101 million municipal bond fund's assets. And like many other municipal bond mutual funds that loaded up on the Caribbean island's debt, the John Hancock fund has generated a dismal return for investors so far in 2013.

Some U.S. money managers have been enticed by the tax-exempt status of Puerto Rico bonds and juicy yields that have topped 8 percent in recent trading.

But danger was lurking. The S&P Municipal Bond Puerto Rico index declined 8.88 percent in August, compared to a 1.68 percent loss in the S&P National AMT-Free Municipal Bond Index, as dealers already spooked by Detroit's bankruptcy fretted about the island's fiscal stability.

In a further sign of the growing perceived risks, Puerto Rico's spread ballooned to 320 points last week, the widest for 10-year bonds over Municipal Market Data's triple-A scale and nearly double Illinois' 165-point spread.

Funds that bet heavily on Puerto Rico are now some of the worst performers among municipal bond funds in 2013, according to an analysis of data from Lipper Inc, a Thomson Reuters service.

Of the 20 municipal bond funds with the highest percentage of Puerto Rican debt, 16 are getting beat by at least 60 percent of their peers.

Puerto Rico bonds are attractive to U.S. municipal bond managers because they are exempt from federal, state and local income taxes in any U.S. state. Investment in Puerto Rico is within bounds for a single-state municipal bond fund as long as at least 80 percent of its income is state tax-exempt, according to the Securities and Exchange Commission's fund naming rules.

Puerto Rico is one of the top issuers of bonds in the United States with $52 billion in outstanding tax-supported bonds compared to $96 billion in California. Investors, however, are often not aware of Puerto Rico's weighting on their state municipal fund.

"When buying a Connecticut municipal bond fund, for example, one would expect Puerto Rico to have as much bearing on the portfolio as Alaska," Morningstar analyst Steven Pikelny warned in December. "This would be a big mistake."

RISKY BET

With chronic double-digit unemployment rates and a dwindling population, the U.S. commonwealth of Puerto Rico has long run substantial budget gaps. The island has yet to produce balanced budgets sought by institutional investors and bond analysts alike.

Investors have pulled money out of municipal funds for 14 straight weeks, owing largely to Detroit's largest municipal bankruptcy in U.S. history, problems in other cash-strapped American cities and concerns about Puerto Rico, according to analysts. The concerns have whipsawed the $3.7 trillion municipal bond market, which is now taking a closer look at Puerto Rico's large, unfunded retiree obligations and persistent deficits.

"While Puerto Rico yields are high, the risks are high too," said Michelle Knight, who runs $600 million in muni bonds at Boston's Silver Bridge Advisors. "This is a structurally flawed economy with unsustainable debt levels that has too many black marks to make it enticing, at least to me."

Managers of Franklin Templeton's $581 million Double Tax-Free Income Fund did not think so. With about 63 percent of its assets in Puerto Rican debt, the fund had the highest allocation among municipal bond funds, according to Lipper. The fund also is down 13 percent this year.

A spokesman for Franklin Templeton said money managers were not available to comment for this story.

John Hancock's Massachusetts fund is down 8.77 percent during the first eight months of 2013, lagging 87 percent of the funds in its category. John Hancock funds are part of Canada's Manulife Financial Corp.

In contrast, Fidelity's $2 billion Massachusetts Municipal Income Fund, with only about 2 percent of its assets in Puerto Rico debt, is down 5.93 percent, or better than 80 percent of its peers, according to Morningstar.

On March 13, S&P cut its general obligation credit rating for Puerto Rico to BBB-minus, or one notch above junk status, warning Puerto Rico's fiscal problems were proving difficult to fix.

But even after that dire warning from a top U.S. credit ratings agency, the John Hancock fund still liked Puerto Rico debt.

"Despite the volatility, we are maintaining the fund's position in Puerto Rico bonds," said Dianne Sales, the fund's portfolio manager, in a semiannual report for the period ended May 31.

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