In the past month, both Moody's and S&P downgraded Puerto
Rico's general obligation debt to below investment grade. As my
colleague Peter Hayes
indicated in a recent Blog post
, Puerto Rico debt has been trading as non-investment grade since
last summer, and the new ratings really reflect current pricing and
As with any noteworthy downgrade, the news sparked a couple of
inquiries from iShares investors. Does my muni fund hold Puerto
Rico debt? If so, how much? What is the impact to the fund?
Fortunately, the answer to these questions is simple:
None of the municipal bond iShares funds, including the iShares
National AMT-Free Muni Bond ETF (
), hold any Puerto Rico debt as of January 31, 2013. MUB and some
of the Muni Series funds did hold some Puerto Rico debt previously,
but S&P had announced back in December that they would be
removing Puerto Rico and other territories from their National
indices as of Jan 31. We sold the Puerto Rico bonds we had been
holding in accordance with the index change.
This news of the downgrade only sparked a couple of inquiries
because most investors knew how to get the answer as we put the
holdings of all of our funds up
on our website
every day. Anyone can go online and see exactly what bonds each
fund holds and how much. And in today's market, this is exactly the
kind of transparency that many investors are looking for.
According to Morningstar almost 70% of municipal bonds mutual funds
hold Puerto Rico bonds as of February 6, 2014.
So why do so many funds hold Puerto Rico debt? The reason
is that they enjoy a unique tax advantage. Most municipal debt is
exempt from Federal taxes, along with state taxes if you are filing
in the same state as the issuer. If you buy your local muni bond
then it will even be exempt from local taxes. For this reason
investors in high tax states, like California or New York, tend to
prefer bonds from their state. What is unique about Puerto Rico
debt is that every US investor enjoys the triple tax exemption,
regardless of where they live. So if I am a California investor
then from a tax perspective I prefer California bonds, as well as
those from Puerto Rico. And if I am a New York investor I prefer
New York bonds, as well as those from Puerto Rico.
As a result, most municipal bond funds own Puerto Rico debt.
This includes national funds, where you would generally expect a
multitude of issuers, as well as state funds. This second fact is
often more of a surprise for investors. Imagine that you live in
New York and buy a New York state muni fund. You might assume that
all of the bonds in the fund are from issuers in your state. You
might be surprised to find that the fund also owns Puerto Rico
debt. For years most investors didn't think much about this as the
debt still had the same tax advantage as their state debt, and
Puerto Rico was viewed as a stable credit that provided some yield.
With the downgrade of the debt, I expect that investor sentiment is
going to shift. Municipal bond fund investors should, and I
expect will, want to take a closer look at their state muni bond
fund to understand their Puerto Rico exposure.
I don't know what will ultimately happen with Puerto Rico debt.
Given the current trajectory of their economy and deficit it seems
likely that some sort of restructure of their debt may be
necessary. For this risk longer maturity bonds are yielding over
8%, and that's more than 13% on an after tax basis for folks in a
40% or greater tax bracket. A good value? Only time will tell. For
now, just make sure that you know what you own and are comfortable
with the risk.
Matthew Tucker, CFA, is the iShares Head of Fixed Income
Strategy and a regular contributor to
. You can find more of his posts