The other big default

As you read this, the U.S. stock market is selling off because Greece is teetering closer to default. But life is not good in the municipal bond market today, either. The reason: The governor of Puerto Rico has announced that the U.S. commonwealth cannot pay its debts.

How bad could that be? Pretty bad, actually. The island has about eight times as much municipal debt as Detroit does. Puerto Rico’s muni bonds were wildly popular with investors because their income was free from state and local taxes for residents of every state in the Union. And, because states and commonwealths can’t go bankrupt, investors figured they were safe.

Whoops. “The debt is not payable,” Mr. García Padilla, the island’s governor, told The New York Times. “There is no other option. I would love to have an easier option. This is not politics, this is math.”

puerto ricoYou might be thinking, “But I don’t own any Puerto Rico muni bonds!” But if you own a muni bond fund, it’s fairly likely you do. One of the largest muni bond funds is Oppenheimer Rochester Fund Municipals, a $6 billion fund. It has 27% of its portfolio in Puerto Rico bonds. Franklin Templeton Double Tax-Free fund, a $223 million fund, has 49% of its portfolio in Puerto Rico bonds.

But the biggest shock might come to holders of Oppenheimer Rochester Maryland Municipal fund, which is aimed at Maryland residents. The $60 million fund has Puerto Rico bonds stuffed into it like crabmeat in the Saturday night special on the Eastern shore. To be exact: The fund has 48% of its portfolio in Puerto Rico bonds, according to Morningstar.

The state-specific Oppenheimer Rochester funds seem to have a fondness for Puerto Rico. The Virginia muni fund has 39% of its portfolio in Puerto Rico; the Pennsylvania fund has 35%.

As of Friday, most of the Oppenheimer muni funds were showing modest positive total returns. Because Puerto Rico can’t go bankrupt, it’s likely it will try to negotiate longer payout periods or even partial debt forgiveness from its bondholders. And that, in turn, will push keep its bond prices down for some time to come.

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