BOSTON (Reuters) - The downgrade of Puerto Rico’s debt to junk status earlier this month has resulted in a rough ride for some municipal bond funds that focus on the debt of specific states.
Many managers of single-state fund managers hunting for juicy returns and a way to diversify their holdings have relied heavily on Puerto Rico’s high-yielding bonds, which are tax-exempt in every U.S. state.
“We won’t invest in Puerto Rico debt again until it returns to investment grade,” said Clark Wagner, who oversees $1.5 billion as director of fixed income for First Investors. “That could take several years.”
Hardest hit are portfolio managers who run funds focused on states like Oregon, South Carolina and Michigan, which have a relatively small number of debt issuers. They may have to hold more cash or lower-yielding debt, two options that will dampen returns.
But the impact of Puerto Rico’s downgrade to junk status by all three major ratings agencies — Standard & Poor’s, Moody’s Investors Service and Fitch — extends beyond just a few states.
Researchers at Morningstar Inc found that about 180 municipal bond funds, representing more than $100 billion in net assets, carry 5 percent or more exposure to Puerto Rico. Many of these funds are state-specific, stretching from New York to California.
“Some overweighted Puerto Rico to an extreme extent,” said Mark Sommer, a lead portfolio manager at Fidelity Investments. “Some managers have surprised their investors with their concentrations in Puerto Rico. But the investor base is waking up.”
Tax-exempt municipal bond funds appeal to individual investors, especially in states with high personal income tax rates and large concentrations of wealth. For single-state municipal bond funds, at least 80 percent of their income must be exempt from state taxes, according to the Securities and Exchange Commission’s fund naming rules. While income from municipal bonds is typically only tax-exempt in the issuing state, debt from Puerto Rico, as a U.S. territory, enjoys tax-exempt status in all states.
The loss or curtailment of Puerto Rico as an investment option has compounded problems for state-specific funds.
State-specific municipal funds had $22.1 billion in outflows during 2013, lowering their year-end assets to $147 billion. That tracked the overall $502 billion municipal bond fund market, which experienced $58.1 billion in total outflows as the Federal Reserve’s tapering discussion spooked bond investors.
Detroit’s bankruptcy and renewed concern over Puerto Rico’s chronic deficits also prompted investors to pull money from municipal bond funds.
Even in the best of times, First Investors’ Wagner said he needed to scour every corner of Oregon’s municipal bond market to find enough debt for his $50 million mutual fund.
Wagner, who relied partly on Puerto Rico’s tax-exempt bonds to round out his portfolio, said he doesn’t want to be left holding too much cash in the First Investors Oregon Tax Exempt Fund, especially if the bond market rallies this year.
Without Puerto Rico in the mix, Wagner’s hunt for appropriate bonds for the long-term Oregon portfolio gets that much harder.
Brian McGreevy, a portfolio manager who oversees more than $5 billion in municipal bond fund assets at Columbia Management, said even funds that focus on states with plenty of issuance have leaned on Puerto Rico debt.
Fund managers focused on Virginia, for example, have relied on Puerto Rico to bolster returns because that state is top-heavy with lower-yielding Triple A-rated debt, McGreevy said.
Reporting by Tim McLaughlin; Editing by Richard Valdmanis and Leslie Adler