U.S. bond funds sue Puerto Rico, worried about bankruptcy threat

June 30 Mon Jun 30, 2014 10:21am EDT

June 30 (Reuters) - U.S. mutual funds holding about $1.7 billion in Puerto Rico debt have sued the cash-strapped commonwealth, accusing the Caribbean island of passing an act modeled after the U.S. bankruptcy code in what could be a potential threat to American investors.

Passage of the act has spooked the $3.7 trillion U.S. municipal bond market, sending down prices of revenue bonds issued by Puerto Rico's electric authority. U.S. municipal bonds funds are the largest holders of the island's debt because it is tax-exempt in every state.

Puerto Rico is one of the largest issuers of debt in the U.S. municipal bond market. Under its constitution, Puerto Rico doesn't have the power to enact a bankruptcy law for the adjustment of its debts. The complaint contends Puerto Rico passed an act modeled after title 11 of the U.S. Bankruptcy code, which is used by U.S. corporations to reorganize.

Bond funds run by OppenheimerFunds, a unit of insurer MassMutual Financial Group, and Franklin Templeton, filed an amended complaint against the commonwealth on Sunday in U.S. District Court in Puerto Rico. The two fund groups are among the largest investors in the beat-up electric revenue bonds.

The funds are asking a federal judge to declare that Puerto Rico's recently passed Public Corporation Debt Enforcement and Recovery Act violates the U.S. Constitution.

"The Act purports to offer to certain public corporations within the Commonwealth the ability, among other things, to invoke protections from creditors and modify debts," the funds said in the amended complaint. "The Act is expressly modeled on title 11 of the United States Code."

Franklin Funds, a unit of Franklin Resources Inc, holds about $907.2 million in revenue bonds issued by the Puerto Rico Power Authority (PREPA). Oppenheimer's Rochester funds hold about $821.4 million in the PREPA bonds, according to the complaint.

Last week, Fitch Ratings downgraded the PREPA to "CC" from "BB" after the act was passed. Since passage, long-dated PREPA bonds, or those maturing in 20 years or beyond, have dropped by about 15 percent, according to the complaint. Short-dated bonds, or those maturing over the next four years, have fallen as much as 40 percent, the complaint said. (Reporting by Tim McLaughlin; Editing by James Dalgleish)