On August 3, Puerto Rico missed a payment to bondholders for the first time. The default was not a big surprise, given the island’s weak economy and heavy $72 billion debt load.1 A painful recession has persisted for nearly a decade, while Puerto Rico’s debt-to-GDP ratio spiked to more than three times that of any U.S. state or territory.2
Tax-friendly municipal bonds, sold by state and local governments to finance public-works projects, are a key component of the portfolios of many investors who depend on the stable income. Puerto Rico’s bonds also have municipal status, but the U.S. territory’s municipalities don’t currently have a legal right to file for bankruptcy under Chapter 9, as Detroit and some other struggling cities have done in recent years.3
Nonetheless, additional defaults could be in store, and the fallout from Puerto Rico’s dire fiscal situation may continue to affect U.S. municipal bond and mutual fund investors.
Puerto Rico’s Issues
Puerto Rico has issued three different kinds of debt. The first default by the Public Finance Corporation involved appropriation debt, which is considered the riskiest of the three because payments depend on the legislature’s willingness to provide funds. General-obligation (G.O.) bonds have first priority under the commonwealth’s constitution, and revenue bonds are backed by dedicated revenue sources, such as public utilities.4
Officials are working on a proposal to restructure Puerto Rico’s debt, while major creditors are pressuring the government to meet its obligations.5 It might take years for Puerto Rico’s financial mess to be ironed out, and bondholders could suffer some losses in the process.
The Merits of Munis
Puerto Rico’s debt problems are fairly isolated and not expected to weigh heavily on the nation’s broader $3.7 trillion muni market.6 The U.S. economy is more than six years into a slow but steady economic expansion, and the default rate of the S&P Municipal Bond Index, which follows bonds of more than 22,000 issuers, was just 0.17% in 2014.7
Municipal bond interest is generally exempt from federal income tax and is usually exempt from state and local income taxes for investors who live in the state where a bond was issued. However, selling a municipal bond or tax-exempt fund at a profit could trigger capital gain taxes. (The interest on bonds issued outside an investor’s state of residency could be subject to state and local taxes, and some municipal bond interest could be subject to the federal alternative minimum tax.)
Because government entities have the power to raise taxes and fees to pay the interest, municipal bonds are generally considered to be higher-quality assets than taxable bonds such as corporates, so they typically pay less interest. The lower tax-free yields offered by muni bonds and tax-exempt mutual funds are often more valuable to investors in the top tax brackets. For example, a 3% tax-free yield is equivalent to a 4.62% taxable yield for an investor in the 35% federal income tax bracket.
Bond Fund Exposure
Nearly 20% of U.S. bond funds, including about half of municipal bond funds, hold Puerto Rican debt, with exposure varying widely from less than 1% to nearly 50% of fund assets.8–9
How did so much Puerto Rican debt end up in the portfolios of so many U.S. municipal bond funds? Because Puerto Rico is a U.S. territory, its bonds are not subject to any federal or state taxes regardless of where the investor lives, which allows them to be included in muni funds intended to be tax-free for residents of a single state. Some fund managers might also have been reaching for more generous yields, which are typically associated with a higher level of risk.10
For individual investors, owning an assortment of munis in a mutual fund makes it easier to attain credit diversification. However, Puerto Rico serves as a reminder that some muni funds are more diversified than others, and it highlights the importance of looking closely at any bond fund’s underlying investments. (Diversification is a method used to help manage investment risk; it does not guarantee a profit or protect against loss.)
Headline Risk Remains
Municipal bond prices may continue to fluctuate as events in Puerto Rico unfold. But credit jitters could also create opportunities for buy-and-hold investors who are willing to ride out periods of market volatility.
The return and principal value of bonds and mutual fund shares fluctuate with changes in market conditions. When redeemed, they may be worth more or less than their original cost. Bond funds are subject to the same inflation, interest-rate, and credit risks associated with their underlying bonds. As interest rates rise, bond prices typically fall, which can adversely affect a bond fund’s performance.
Mutual funds are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.
1) The Wall Street Journal, August 3, 2015
2) Kiplinger.com, July 22, 2015
3) CNNMoney, July 1, 2015
4–5) Bloomberg.com, August 3, 2015
6, 8, 10) The New York Times, July 24, 2015
7) S&P Dow Jones Indices, 2015
9) Investor’s Business Daily, August 13, 2015
The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Emerald. Copyright 2015 Emerald Connect, LLC.