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NEW YORK (Reuters) - It looked like there was no stopping the runaway returns for high-yield U.S. municipal bonds earlier this year. But that has all come to a screeching halt in the past few weeks thanks to a bombshell coming out of the Caribbean.
The island of Puerto Rico shocked investors by passing a law that gives its government-controlled corporations the ability to restructure their debt. Until that point, many investors assumed that the government of the U.S. territory would stand fully behind the bonds, although there was never a promise to do so.
The impact has been dramatic because Puerto Rico’s government and related entities have $73 billion of outstanding debt, nearly $20,000 for every resident of the island, and it has been widely held by U.S. high-yield muni funds. Some of the biggest funds were heavily overweight in Puerto Rican debt and have taken a battering as a result.
The benchmark Barclays High Yield Municipal Bond Index, which had been up more than 9.5 percent for the year as of mid-June - when it looked like it was going to have its best year since record-beating returns in 2009 - is now up only 5.9 percent.
The hit Puerto Rico bonds have taken following the law's passage accounts for a sizeable portion of the drop off in performance. Puerto Rico's weighting in the index has surged to 29.3 percent from less than 5 percent at the start of the year because more of its debt qualified for inclusion after it was slashed to junk by U.S. ratings agencies.
"Puerto Rico had a significant impact on the performance in high yield," said James Colby, chief municipal strategist at Van Eck Global.
Colby and some other investors expect the sector to remain under pressure given they see little chance of a sustained turnaround in Puerto Rican debt anytime soon.
"We’re not looking at the bottom, near term or any time soon," he said.
Colby oversees the $1.05 billion Market Vectors High Yield Municipal Index ETF, designed to mirror Barclay's high-yield muni index. The fund, which has 4.2 percent of fund assets in Puerto Rico debt at the end of June, although it remains up 7.6 percent for the year.
"It has also caused some managed funds to do some selling in anticipation of redemptions," said Colby said, adding that he believes some tobacco settlement bonds were sold for this reason.
More widely, the fallout from Puerto Rico could be a sign of wider stresses to come in the financial markets – particularly among higher-risk assets. Catalyst for this could be the U.S. Federal Reserve plans to ends its bond buying program by October and expectations it will raise interest rates next year for the first time since 2006.
Also in recent days, spreads on corporate junk bonds have widened and stocks have been whipsawed by fresh concerns about the banking sector in peripheral Europe.
The greatest concern in Puerto Rico centers on the solvency of its long-struggling power company, known as PREPA, which has around $9 billion of debt and has already been forced to arrange a grace period until the end of July on a line of credit that expired some months ago.
Ratings agencies, who have downgraded virtually all stripes of Puerto Rican debt deeper into junk territory after the law was passed, said the legislation raised questions about the government's willingness to pay its debt, including its general obligation bonds.
It is a view shared by some investors.
"It changed the liquidity characteristics ... almost overnight," said James Grabovac, a senior portfolio manager at McDonnell Investment Management in Illinois.
Puerto Rico bonds are widely held in the U.S. muni market because of their triple-tax free status and juicy yields, typically above 8 percent compared with around 3.4 percent for top-rated muni bonds.
In the week to July 9, investors pulled $691 million out of high-yield muni funds, the biggest such outflows in a year, according to data from Lipper, a Thomson Reuters unit. It was a sharp reversal for a sector that had seen consistent inflows since January.
Among the biggest losers was the Oppenheimer Rochester High Yield Municipal Fund.
It suffered a negative return of 1.92 percent in the month to last Friday. That dropped its 12-month performance to a gain of 5.93 percent. The fund shed nearly $294 million across all share classes for the week ending July 9, more than any other individual high-yield muni fund, Lipper data showed.
Just over 11 percent of the fund had direct exposure to Puerto Rico debt, nearly all of it uninsured.
The Franklin Double Tax-Free Income Fund, run by Franklin Resources Inc, also tumbled just after the legislation passed. The fund returned negative 6.65 percent over the past month.
By comparison, the Barclays municipal benchmark index is up 5.6 percent year-to-date.
The Franklin fund currently has about $285.7 million in assets, the lowest since Lipper began collecting data in 2008, following 23 straight months of investor redemptions and poor performance. About 62 percent of the assets are invested in Puerto Rico bonds, according to Lipper.
Fund managers for Oppenheimer and Franklin were not available to comment, spokeswomen for each firm said.
Both firms have sued Puerto Rico over the new law, saying it is unconstitutional because only the U.S. Congress can enact bankruptcy laws.
Across all of its funds, Franklin holds almost $1 billion of PREPA debt. Oppenheimer funds hold $821.4 million of PREPA bonds, according to the lawsuit.
The price on PREPA's 7 percent bonds due in 2040 have slumped to less than 40 cents on the dollar compared with 70 cents before the law was passed. Their yield, which moves in the opposite direction to its price, has shot up to nearly 18 percent from 10.4 percent.
Not everyone has been taking a shellacking in the sector.
Two of the biggest high yield muni funds, run by Invesco and Nuveen, managed to sidestep much of the high-yield maelstrom by largely or completely avoiding Puerto Rico.
Invesco's $6.6 billion High Yield Municipal Mutual Fund has slipped fractionally in the last month but remains up 9.7 percent on the year. Its biggest geographical exposure is to bonds from Texas and California.
And Nuveen's $9.1 billion High Yield Municipal Bond Fund is up 0.3 percent in the last month and 12.4 percent for the year. Its heaviest weighting is in debt from California and Florida.
John Miller, co-head of fixed income at Nuveen Asset Management LLC, told Reuters in May that the high yield fund owned no Puerto Rico debt, saying he sees no "catalyst for a turnaround in Puerto Rico."
Reporting by Hilary Russ; Additional reporting by Tim McLaughlin; Editing by Dan Burns and Martin Howell