What Puerto Rico's Debt Crisis Means for Muni Investors

NEW YORK (TheStreet) -- While the financial world focused on the Greek debt drama, a problem with even bigger potential consequences has been brewing in the Caribbean.

Puerto Rico can't pay its $72 billion of debts, the governor of the island warned Sunday, just two days before a budget deal needs to be approved by the territory's legislature. It could affect U.S. investors such as mutual fund holders in a much larger manner than events in Greece. 

"[Puerto Rico] is close to home and getting messy," Peter Tchir of Brean Capital wrote in a recent research note. "We (or at least me) weren't focused on a problem much closer to home, with much larger P&L ramifications" than Greece.

Much, but not all, of the focus of the worry by investors is a very liquid tranche of Puerto Rican general obligation bonds due in 2035 that hold an 8% coupon. Investor reaction to the news that the territory cannot pay its debts sent prices for the securities down 8 points to 69 cents on the dollar overnight, according to bond fund powerhouse PIMCO.

"It means people think it will default," says David Hammer, a PIMCO municipal bond portfolio manager.

The amount is actually far worse than the $72 billion widely quoted, which doesn't include unfunded pension liabilities and expected health-care liabilities, he said. When you add those, the total cost is in excess of $100 billion, Hammer said.

"We've been looking at Puerto Rico's debt load as unsustainable for quite some time," he added. PIMCO sold the last of its Puerto Rican debt in early 2013.

For investment grade, or non-risky, mutual funds, there likely isn't a problem for investors as savvy fund managers will have followed Hammer's lead and dumped the securities. But that doesn't mean the bonds have ceased to exist. Some tranches ended up in so-called high-yield municipal debt funds.

"For your high-yield funds, you should know what they hold," said PIMCO's Hammer. That's easy enough to find out, using Morningstar's fund screener. 

A sampling of just a handful of the 192 funds that Morningstar listed showed tremendous variation:

-- The Dreyfus High Yield Municipal Bond Y held no Puerto Rican securities in its top 25 holdings as of April 30, Morningstar indicates.

-- The American Century High Yield Muni (AYMAX) held some 8% Puerto Rican bonds in its top 25 holdings as of March 31, but it was less than 1% of assets.

The Columbia High Yield Muni A Load Waived (LHIAX) had the Puerto Rican 8% bonds as its top holding, but it was only 1.33% of the total value as of March 31.

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