Keep your eye on the Puerto Rico bond saga

Puerto Rico’s debt default should be a lesson for investors and their advisers: Even apparently low-risk investments, such as municipal bond mutual funds, must be monitored regularly.

And the default shows once again that high returns probably mean high potential risk, and sometimes that risk bites investors.

As InvestmentNews reported last week, a number of municipal bond funds were caught with high levels of Puerto Rican bonds in their portfolios. That could be expected in high-yield muni bond funds that were reaching for return and, given their names, likely were taking higher-than-average risk.

SINGLE-STATE FUNDS

But even some single-state mutual funds, such as the Oppenheimer Rochester Ohio Municipal bond fund, had 14.6% of its assets in Puerto Rican bonds as late as April 2015, according to Morningstar. An investor buying into that fund likely was an Ohio resident looking for the tax benefits, and would not expect to find Puerto Rican bonds in the portfolio at all.

In addition, some individual investors might have bought Puerto Rico debt for its yield, either on their own or on the advice of an adviser. They will likely suffer.

The problems in Puerto Rico didn’t arrive suddenly and didn’t creep up on investors or lenders. The warning signs were clear. The Standard & Poor’s credit rating for the island was A- until 2005, when it fell to BBB; in May of 2007 that was cut to BBB-. In February 2014, S&P downgraded the island’s general obligation debt to BB+, one level below investment grade. Three days later Moody’s cut its rating to two levels below investment grade.

Yields on Puerto Rico debt have been rising over many years, signaling trouble was looming. For example, yields on 10-year general obligation debt have been rising at least since 2012, when they were close to 5%. In October 2015, they hit 12.3%, even though such bonds are backed by the island’s full faith and credit and its Constitution states they must be paid before other expenses. Other issues show similar increases in the yields demanded by investors, driving the prices of the bonds down.

Puerto Rico’s economy has been in recession for about 10 years, such that the territory’s unemployment rate is 12.2%. The expiration of tax credits, high labor costs caused in part by government regulations and competition from lower-cost countries have driven away much of Puerto Rico’s manufacturing.

The tough economy caused budget shortfalls, which the island’s government financed by borrowing. Now the debt has become so high — $72 billion across all agencies — that the government has to choose between providing basic services and paying its debt obligations. Gov. Alejandro Garcia Padilla has made it clear he will provide the services.

The crisis has reinforced the message that investors can’t assume the federal government will step in to save them — a lesson that should have been driven home by the 2008 financial crisis, during which many bond investors, and even pension beneficiaries, took hits.

While the U.S. Congress is working to devise legislation that will help Puerto Rico, it is trying to do so in a manner that will not encourage future profligacy by Puerto Rico’s government, or other government entities. Puerto Rico debt holders likely will take haircuts in any such rescue legislation.

LESSON IN MINDFULNESS

No doubt many muni mutual funds that held Puerto Rico debt in previous years cut or eliminated their positions as the dire fiscal situation became clear, saving their investors from financial pain. And some of the Puerto Rico debt is protected by insurance against default.

But the lesson remains. Investors and advisers must regularly monitor their investments, even apparently safe mutual funds, to make sure they are not taking on increased risk.