Two top bond fund managers are suing Puerto Rico, arguing a plan by lawmakers that could provide relief on some debt obligations violates the U.S. Constitution.
The lawsuit, which was filed on Saturday and first reported late Sunday by the Wall Street Journal, came as the fund firms — Franklin Templeton Investments and OppenheimerFunds — fought against the prospect that investors in municipal bond funds could face a debt restructuring process and a loss on their investments.
The majority of both OppenheimerFunds' and Franklin's municipal debt products, which combined have assets of nearly $84 billion, were listed as plaintiffs in the lawsuit.
A law passed last week by Puerto Rican legislators could provide government agencies like a Puerto Rican power utility the ability to renegotiate debts with their creditors while maintaining ongoing services, according to an English-language description of the law posted on a government website.
The lawsuit, Franklin California Tax-Free Trust et al. vs. Commonwealth of Puerto Rico et al., was filed in the U.S. District Court in San Juan, and seeks to have the law overturned.
Some observers see the passage of the Puerto Rico Public Company Debt Enforcement and Recovery Act as a potential indication that investors may suffer losses in a debt restructuring. Moody's Investors Service, Standard & Poor's and Fitch Ratings this month downgraded nearly $9 billion in securities issued by the Puerto Rico Electric Power Authority, with some citing the law among factors contributing to their decisions.
Funds by Franklin and OppenheimerFunds hold $1.7 billion in bonds issued by the self-funded utility, which provides electricity to nearly 1.5 million households and businesses on the island.
In their complaint, the fund companies said only the U.S. Congress has the constitutional authority to pass bankruptcy laws. A spokeswoman for Franklin Templeton declined to comment on the suit.
"We believe it is our responsibility to stand up for the rights of bondholders and our shareholders when the unlawful acts of issuers or others threaten those rights," a spokeswoman for OppenheimerFunds said in an email.
(See also: OppenheimerFunds loses more bond bets)
The fund companies said short-dated bonds issued by the agency have declined by nearly 40% since the Senate approved the law, which does not apply to general-obligation bonds or others directly backed by Puerto Rico's taxing power.
Overall, the market has been kind to Puerto Rican bonds this year, after a disastrous 2013. The S&P Municipal Bond Puerto Rico Index is up 6.65% year to date, as of last Friday, after having lost nearly 13% over the last year. That compares with the Barclays Municipal Bond Index, which is up less than 6% this year.
Two thirds of U.S. mutual funds have exposure to the Caribbean island's debt, according to research firm Morningstar Inc., in part because of the favorable tax treatment for investors who hold those assets.
“I feel bad for the government,” said Daniel Fuss, manager of the $23.8 billion Loomis Sayles & Co. Bond Fund, in an interview before the act was passed. “They're between a rock and a hard place … It's up to the U.S. at a national level — the Congress — as to whether or not they're able to continue to service the debt.”
Puerto Rican government officials could not be reached by telephone Monday, but in a statement quoted by the Journal, the territory's Government Development Bank said it stood by the law, which it said was necessary “to fill a gap in the existed federal insolvency regime and ensure the continuity of critical public services.”
In a market analysis last week, Rafael Costas, co-director of Franklin's municipal bond department, said prices on bonds will continue be volatile as news develops in Puerto Rico.
“Puerto Rico is facing a mountain of obligations, its economy is not really growing and its government is trying to figure out how to get the economy growing again,” said Mr. Costas. “We are long-term investors, and we hope that in the long term things will work out and Puerto Rico should be on a better fiscal and economic path.”