Despite congressional relief, impending Puerto Rico debt default could trip up municipal bond investors

OppenheimerFunds, Franklin Templeton maintain big exposure to the troubled island's debt.

As Puerto Rico inches ever closer to defaulting on its next debt payment, Congress has stepped up to try to help the island find a way out of its suffocating financial woes, which includes $70 billion worth of debt on top of $40 billion in underfunded pension liabilities.

For investors and financial advisers who haven’t done so already, this would be a good time to re-evaluate those municipal bond investments, because there is a better-than-average chance your muni bond fund has some exposure to Puerto Rico’s hazardous debt.

Puerto Rico, which, unlike other U.S. municipalities, is prohibited by law from filing for bankruptcy, will get some help from the financial control board that has been approved by Congress. President Barack Obama signed off on the plan Thursday.

But while the as-yet unformed board will try to help Puerto Rico manage its bills, the default on a $1 billion debt payment is still expected Friday.

According to Morningstar, there are hundreds of muni bond funds with varying degrees of exposure to Puerto Rico’s debt, with some fund companies clearly more bullish than others on the bonds.

OppenheimerFunds and Franklin Templeton Investments stand out for having Puerto Rico bonds in the majority of the their muni bond funds.

At OppenheimerFunds, 19 of the 20 muni bond funds have exposure to Puerto Rico, while 24 of 32 Franklin Templeton muni bond funds have exposure to Puerto Rico.

Also, OppenheimerFunds has 17 of the top 18 muni bond funds ranked by exposure to Puerto Rico.

While the bonds are cheap, and may be easy for a portfolio manager to justify buying, if the next shoe drops in the Puerto Rico saga in the form of a default, the lack of debt payments will cut off the dividend income, diminishing the value of the bonds inside the mutual funds.

Ron Bernardi, president and chief executive of Bernardi Securities, is hopeful the new financial control board will be able to sort out the pecking order for all the interested parties owed money by Puerto Rico, from senior bondholders down to “coffee vendors” providing services to government offices.

“The fact that Congress did not give Puerto Rico permission to file bankruptcy has delayed the potential mistreatment of bondholders, but it’s still reasonable to assume that bondholders will have to take some kind of a haircut,” he said. “We need some order around this, because we cannot have another Detroit-style situation where local officials come in and throw the general obligation bondholders in with everybody else.”

Mr. Bernardi, who does not own any Puerto Rico debt, has been a vocal critic of the way recent municipal bankruptcies, including Detroit, have been restructured without giving senior debt holders appropriate seniority in recovering losses.

“It will be fascinating to watch, and hopefully in Puerto Rico the legislation won’t permit them to be as caviler to holders of general obligation bonds, which are supposed to be constitutionally guaranteed,” he said. “I am heartened to see Congress vote for this board to ensure that local officials in Puerto Rico can’t just thumb their nose to bondholders.”

Franklin Templeton spokeswoman Stacey Coleman said even though the asset manager has been an investor in Puerto Rico for more than 30 year, “beginning in 2012, we began reducing exposure to Puerto Rico-related bonds, due to the weakening financial conditions on the island.

“We retained those investments that we believed were the strongest position and had significant legal and constitutional protections,” she said. “Currently, none of our municipal bond funds have more than 5% of their total net assets invested in Puerto Rico, and some have no exposure.”

OppenheimerFunds, which has been investing in Puerto Rico’s bonds for more than 20 years, offered a statement expressing support for the financial control board.

“We view the passage [of the legislation] as a positive for bondholders and for Puerto Rico,” said OppenheimerFunds spokeswoman Kimberly Weinrick. “The control board will be able to obtain audited financial statements, approve Puerto Rico’s budget, and help to encourage good faith negotiations between the commonwealth and bondholders.”

Ms. Weinrick did not elaborate on OppenheimerFunds’ commitment to Puerto Rico in light on the looming default, but the outlook is not bright according to Chris Ryon, managing director and muni bond portfolio manager at Thornburg Investment Management.

“For any mutual fund that owns these bonds, Puerto Rico has said they are going to default on everything tomorrow,” he said. “If an issuer goes into default, your dividend that you pay to shareholders stops. Shareholders have already seen net asset values go down, but haven’t seen dividends cut yet, and we know shareholders don’t like dividend cuts.”

Mr. Ryon, who doesn’t own any Puerto Rico bonds, said the appeal of the debt for portfolio managers is part of the fabric of a muni bond fund manager.

“Muni bond portfolio managers tend to be nothing more than yield strumpets,” he said. “We buy cheap things, and we sell our financial virtue very cheaply.”