One of the first things I learned cutting my teeth in the investing world was to avoid municipal bonds from Puerto Rico.  My mentor liked to refer to the US Territory as a banana republic.  “That my friend is a ticking time bond waiting to blow up in your clients’ face!”

Puerto Rico formally defaulted on its municipal debt obligations last week by making a $628,000 partial interest payment on the $58 million it actually owed.  Perhaps, the Puerto Rican Public Finance Corporation (PFC) knew this was their only legal requirement given the bleak situation.  If you dig into the PFC’s debt contracts, it states that interest payments can only be made when the PFC has appropriated funds for them.  Since the PFC does not, there appears to be no legal requirement for Puerto Rico to pay the debt, or any legal recourse for bondholders.

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 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?  It depends if you own any of these funds.  Oppenheimer manages nine of the ten funds with the greatest exposure to these toxic bonds—$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.  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 I mentioned earlier, this isn’t a shock to me.  I learned this back in 1997.  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 way.  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.

The moral of this tale, know what you’re buying and why.  That faint ticking sound you hear inside your portfolio may eventually blow up in your face.

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