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Puerto Rican bonds

Puerto Rico’s debt crisis has been well documented in the financial press. After a decade of economic stagnation, the island nation started missing its bond payments in January, sparking a debt crisis that threatens to bankrupt the entire country. Puerto Rico currently owes $72 billion to bond investors and approximately $46 billion to government pension funds. On 2 May, the country missed a $367 million payment on Government Development Bank notes, and it is widely expected to default on a $2 billion repayment which is due on 1 July.

Governor Alejandro Javier García Padilla has openly admitted that the country is unable to repay these debts, and he has sparked concern that the growing debt crisis could lead to the loss of emergency services and the country’s public pension funds, and mass migration.

But the crisis may have a much wider reach. A recent MPI analysis revealed that 29 out of 562 US municipal bond funds have exposure of between 5% and 50% to Puerto Rico bonds – those same bonds which are now at risk of default. Many of the affected funds are classified as fund ‘families’, meaning that the Puerto Rican investments are offshoots of the main fund, and therefore harder to trace. According to the MPI research, some of these fund families are run by major firms such as Franklin Templeton, Goldman Sachs and Oppenheimer.

“While many municipal funds don’t have a detectable exposure to Puerto Rico, higher concentrations run in a few fund families,” said senior MPI analyst Sean Ryan. “One municipal fund family has 17 of the 29 funds with high levels of exposure. A smaller fund has an exposure approaching 50%.”

Bond investments rely on the government’s ability to pay back investors at the end of the agreed term, but Puerto Rico has been unable to repay any of its bond investors so far this year. Puerto Rican bonds are now trading at an all-time low of less than 63 cents on the dollar, a valuation which will have a knock-on effect on those municipal bonds which are still exposed to the country.

Even worse, if the country continues to miss its repayments and fails to satisfy investors with a plan to restructure the island’s finances, the existing bonds may be relegated to junk status and deemed practically worthless.

How did this happen?

The debt crisis is the end result of years of poor financial management on the island. As an independently-run US Territory, Puerto Rico has been able to set its own tax laws, and since the mid-1970s it has taken advantage of the IRS Section 936 tax code which allowed US corporations to do business on the island without paying any corporate tax. For years, the island’s economy relied on American business, but in 2006 Section 936 expired and Puerto Rico lost its main source of income. In the meantime, the island had run up a huge amount of debt by issuing bonds with attractive tax incentives, usually to domestic and US-based investors.

Local governments have also been blamed for poor budgeting decisions and overspending, running up huge bills which were partially funded by bond money and loans from the country’s pension funds.

However, a shrinking population, rising unemployment, and import-reliant economy has led the country into a prolonged economic depression, with no hope of recouping its debt.

In an effort to avoid bankruptcy and protect its external investors, the Puerto Rican government has been appealing to the US for extensions on their loans, and help coming up with a long-term recovery plan. A bipartisan bill has now been introduced in the US in an effort to rescue Puerto Rico’s economy. If it passes, it will place the country’s finances under American control, in a deal which is similar to Chapter 9 bankruptcy in everything but the name.

Whatever is done to help Puerto Rico, it will be a long time before the country is able to return to financial stability and start issuing bonds which are worth buying again.

How to find out if your money is at risk

MPI did not name the 29 funds in question, but if you are worried about your exposure to Puerto Rican debt there are a few steps you can take to find out if your money is at risk.

Check the fund fact sheet

This will usually contain a breakdown of the portfolio by asset class, sector and geographical exposure, so if your bond fund is invested in Puerto Rico you will soon know about it.

If the geographical allocation remains unclear (for instance, if it simply states something like ‘US States and Territories’), you may have to dig a little deeper to work out the total exposure to Puerto Rico. Call the investment team and ask them directly – if they can’t give you a definitive answer, it may be time to move your money.

Trace your fund’s ‘family tree’

Fund of funds are popular investment vehicles which pool money from multiple sources and invest it into a number of offshoot funds. This allows relatively small investors (for instance, individual members of pension fund schemes) to access higher returns from a diversified portfolio of funds which are hand-picked by the fund of funds manager.

In order to track your exposure, you will have to research each and every one of the smaller funds within this fund family, checking their geographical allocation as you go. This can be time consuming, and due to the diverse nature of these portfolios you are likely to find that any exposure to Puerto Rico is negligible (i.e. less than 5%) when compared to the wider returns.

Ask your fund manager

If you are investing in a smaller fund, the easiest way to find out whether or not you are holding Puerto Rican debt is to simply pick up the phone and ask your fund manager. Active fund managers should know where their money is at all times, and they should be able to tell you immediately if you are exposed to the Puerto Rican debt crisis.

Once you know where your money is, it is your manager’s responsibility to either remove this exposure from your portfolio (albeit at a small loss), or to convince you to maintain your allocation.

Related topics:Advice for Investors Global Markets Overview
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