February 21, 2014 / 5:31 PM / 6 years ago

U.S. fund managers juggle Puerto Rico debt, redemptions and rate worries

BOSTON, Feb 21 (Reuters) - Municipal bond fund managers, facing heavy redemptions from funds holding unfavorable debt, have been forced to juggle their holdings to pacify moody retail investors.

U.S. investors over the past 12 months have pulled $20 billion from municipal bond funds stuffed with Puerto Rico’s recently junk-rated debt, and have also spurned longer-duration bonds.

“Never underestimate the irrational behavior of a retail investor,” said Tom Metzold, a municipal bond portfolio manager at Eaton Vance Corp.

In January, investors pulled $1.1 billion from U.S. municipal bond funds with 5 percent or more exposure to Puerto Rico. Meanwhile, the $502 billion municipal bond mutual fund category attracted overall positive flows of nearly $400 million, according to Lipper Inc data.

The exodus from Puerto Rico-heavy funds seemed like a good move before three top Wall Street ratings agencies this month cut the island’s general obligation debt to junk status.

But the cash-strapped commonwealth has since hatched a plan to sell nearly $3 billion in new bonds that would give the island liquidity and some breathing room to repair its flagging economy, sparking a rally in its debt.

“The perceived demand for the deal is strong,” said Chris Alwine, who oversees $100 billion in municipal bond assets at Vanguard Group. The No. 1 U.S. mutual fund company has an underweight exposure to Puerto Rico debt, he said.

The S&P Municipal Bond Puerto Rico Index is up 4.94 percent so far this year, with most of that increase happening in February. That same index fell more than 20 percent in 2013, when net outflows in Puerto Rico-oriented funds totaled $20.2 billion, or 28 percent of $83.4 billion in assets under management, according to Lipper data.


Investors also have exited municipal bond funds exposed to higher interest rates, not just Puerto Rico’s financial woes, according to portfolio managers.

When interest rates spiked last year on fears the Federal Reserve would begin trimming its bond-buying stimulus, returns on municipal bonds with long durations plummeted. Jittery investors pulled $58.1 billion from all U.S. municipal bond funds in 2013, a $108 billion swing from 2012’s positive flows.

Duration is a measure of a bond’s sensitivity to changing interest rates. Long duration bonds, for example, get hurt when interest rates rise, while bonds with short durations are less affected.

Boston-based Eaton Vance Corp’s Oregon Municipal Income Fund , for example, had a duration of 12 years, which is extraordinarily long, said Metzold, who ran the fund until the end of 2013. Eaton Vance’s South Carolina Municipal Income Fund also had a long duration.

“Because of the long duration, they got the stuffing kicked out of them,” Metzold said.

Indeed, the $111 million Oregon fund fell nearly 12 percent last year, underperforming its benchmark by 9 percentage points, according to research firm Morningstar Inc. Outflows totaled nearly $51 million for the 12 months that ended Jan. 31, according to Lipper.

Regardless, heavy outflows have forced municipal bond managers to keep bigger positions of well-known and highly-rated securities, said Guy Davidson, who oversees $30 billion as director of municipal investments at AllianceBernstein Holding LP in New York.

Higher quality bonds can be sold off easily to meet potential investor redemption demands, whereas offloading large blocks of beaten down debt, like Puerto Rico’s, could exacerbate a fund’s losses.

Sometimes fund managers have to sell a little bit of both. Trimming positions too much in quality bonds to meet redemptions would leave a fund with the unintended consequence of higher exposure to Puerto Rico.

Besides, not all of the island’s debt should be unloaded, Davidson said, because the high yields justify the risk.

“Clients want a love-hate story,” he said. “But we make sure investors don’t clump all of Puerto Rico debt together.”

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