You’ve probably read that the island
territory of Puerto Rico formally defaulted on its municipal debt obligations,
over the weekend of August 1st and 2nd, an unsurprising
event that has been expected by insiders for more than three months. What did surprise everybody was the fact that
the Puerto Rican Public Finance Corporation (PFC) found a way to make a partial
payment on its $58 million in interest obligations—even if the amount was only $628,000.
Going
forward, the situation is rather bleak.
The Moody’s credit rating service has noted
that, according to the debt contracts, interest payments can only be made if
and when the PFC has appropriated funds for them. Since the PFC has not done so, there appears
to be no legal requirement for Puerto Rico to pay the debt, or any legal
recourse for bond holders.
A
number of mutual fund companies are probably wishing that they had read these
contracts more closely before buying a big chunk of the territory’s $70 billion in debt on behalf of
their shareholders. Puerto Rican muni
bonds were once considered to be the Swiss army knife of the muni world, since
they qualify as tax-exempt in all 50 U.S. states and therefore can be placed
into any state-specific muni fund portfolio.
They also paid significantly higher interest than most states were
offering—between 9% and 21% right before the
default on 20-year issues, as high as 5% on 2-year notes. The national averages among all U.S. states
are closer to 2.85% and 1%, respectively.
How
much of the default are you, personally, on the hook for? Very little to none at all unless you’re invested in broker-sold Oppenheimer
funds. Oppenheimer manages nine of the
ten funds with the greatest exposure to these daredevil investments—$5.1 billion according to the Morningstar
mutual fund analysis service. The other
fund with high exposure is the Franklin Double-Tax Free Income Fund, which
currently has about 60% of its shareholders’ money
tied up in the Puerto Rican fiasco. Ten
of Wells Fargo’s 14 municipal bond funds have also
wagered on Puerto Rico’s debt, as have 20 of Eaton Vance’s 27 muni funds.
As
mentioned, the default is not exactly a shock.
Puerto Rican bonds, once sold as high-rated paper, have been sliding
down the ratings scale for years, causing losses for investors all along the
journey. A $5 million class action
lawsuit was filed against the brokerage firm UBS as far back as 2013, alleging
that older investors were urged to take out loans in order to load up on risky
Puerto Rican bond funds that brokers touted as safe and secure. An estimated $500 million was ultimately
borrowed to buy into the mess, and investors in those funds suffered at least
$1.66 billion in losses when the suit was filed—two
years before the recent downgrade.
Meanwhile,
the Vanguard and BlackRock organizations eliminated their small positions in
the territory late last year.
