BOSTON Some U.S. municipal money market funds appear to have loaded up on bonds issued by Puerto Rico, whose free-spending ways and chronic deficits have scared off many investors in recent weeks.
But these muni money market funds - which have a reputation to protect as among the world's safest investments - aren't betting on Puerto Rico as a good credit risk. And fund managers say they aren't just chasing juicy yields that have topped 10 percent in the past month.
Instead, they buy Puerto Rico municipal bonds to diversify their holdings without direct exposure to the island's financial turmoil.
The Puerto Rico debt they buy is backstopped by a cross-section of global banks, including Barclays PLC, Citigroup Inc, Deutsche Bank AG and Societe Generale, U.S. regulatory filings show. The debt is short-term, maturing within a month or two, and any default would be absorbed by the banks.
"The credit risk is with the bank. End of story," said Mike Sirianni, a portfolio manager at Federated Investors Inc.
Sirianni runs Federated's $108.2 million Connecticut Municipal Cash Trust, which had 10.5 percent of its holdings linked to Puerto Rico. But the credit on the $11.4 million worth of bonds is backed by Barclays and Deutsche Bank.
Fund company executives are sensitive about having the names of Puerto Rico bonds in their municipal money market fund portfolios. That's because these funds are considered some of the safest investments outside of an insured bank deposit.
And the slide in Puerto Rico bond prices happened just as leading money market fund providers engaged in a pitched battle with the U.S. Securities and Exchange Commission to exclude the muni money market funds from reform that would end their traditional $1 per share price.
Fidelity Investments, Charles Schwab Corp and Federated say that the SEC's proposal to allow share prices to fluctuate would scare off investors. They argue that without the stable $1 share price - the hallmark feature of the money market fund - investors will have less appetite for these investments.
As a result, money funds would have less interest in buying municipal bonds, thereby forcing municipalities to offer higher rates on their debt to attract investors.
Meanwhile, the S&P Municipal Bond Puerto Rico Index is down 15 percent in 2013, badly underperforming a decline of only 3.55 percent on the S&P National AMT-Free Municipal Bond Index.
Overall, U.S. muni money market funds have invested about $1 billion in Puerto Rico debt, said Pete Crane, president of money market research firm Crane Data LLC. That's about 0.4 percent of total muni money fund assets of $260 billion.
Puerto Rico bonds are attractive to U.S. investors because they are exempt from federal, state and local income taxes in any U.S. state.
Puerto Rico bond issuers use credit enhancement, such as bond insurance and bank letters of credit, to secure higher credit ratings. The issuers, not the funds, pay the banks fees to get the backstop, said Nancy Prior, president of Fidelity's $425 billion money fund group.
She said Fidelity does a deep dive on the financial institutions that backstop the Puerto Rico debt held in muni money market funds. She said the banks' obligations are relatively small compared to the size of their balance sheets.
Prior also said Basel III's push to bolster the capital of large banks has "reinforced and heightened" the attention they pay to their credit enhancement obligations.
Municipal money market funds account for about 10.5 percent of the overall $2.6 trillion money fund industry. But they're an essential force in providing states and cities with short-term cash.
As Massachusetts Treasurer Steve Grossman pointed out in a September 17 letter to the SEC opposing reform, state and local governments borrow against anticipated revenue to cover funding gaps for school construction projects, for example.
Puerto Rico is no different. But its general fund deficit for the fiscal year that ended June 30 was about $1.3 billion. Analysts at Municipal Market Advisors said in a research note this week that Puerto Rico's government raised spending by $830 million, or 9 percent.
"An alarming development given the ... supposed laser focus on cost cutting," MMA said in a research note on Monday.
(Reporting By Tim McLaughlin; Editing by Richard Valdmanis and Nick Zieminski)