When most people think of Puerto Rico, they think of sun, sand, rum and tropical vacations. But in the finance world, when we think of Puerto Rico, words like “economic woes” and “bond downgrades” come to mind. But if I’m not planning a trip to this tropical island, why should I care about its economic woes? The answer may surprise you – 70% of municipal bond mutual funds own debt from the Commonwealth of Puerto Rico. Yes, you read that right – 70%!!!  Before I explain the reason for this, let me give you a quick tutorial on this U.S. territory and why it has gotten itself into the headline news recently.

Puerto Rico is an unincorporated territory of the United States. Its residents are U.S. citizens, subject to U.S. federal laws, but because it is not a state, those citizens have no voting representation in Congress. Puerto Rico consists of one main island and several smaller ones, and had a population of about 3.7 million in 2012.

The economy of the island has been in decline for almost a decade. The population has been decreasing, as well as aging, and the territory has a long history of structural budget deficits. Since 2006, the economy has contracted every year except one, and its pension is only 4.5% funded (compared to the worst state in the nation, Illinois, which is over 40% funded). At the end of 2013, the unemployment rate in Puerto Rico was 15.4% (compared to the U.S. unemployment rate of 6.6%) and 41% of the population lives below the poverty line, which is almost double the 22% level for Mississippi, the worst state in the U.S. The Commonwealth of Puerto Rico and its governmental agencies have more than $70 billion in outstanding debt.

So if money managers know about all of these economic problems, why would they buy bonds issued by Puerto Rico? The answer comes down to money, of course. Puerto Rican bonds have historically had higher yields than similar bonds from U.S. states, due to the increased risks. However, the most important factor involves taxes. Bonds issued by Puerto Rican agencies are exempt from both federal and state taxes for U.S. residents. For most U.S. residents, municipal bonds are only exempt from state taxes if they purchase bonds issued by their state. So for example, if you are a resident of New Hampshire, you would pay state taxes on a bond issued by the city of Boston, M.A., but you would not pay state taxes on a bond issued by the city of Concord, N.H. This means that a resident of N.H. can buy N.H. bonds and Puerto Rico bonds with no state tax implications.

So how did Puerto Rico bonds end up being in 70% of all municipal bond mutual funds?

The answer is the same as the reasons we just discussed – yield and state tax exemption. Many mutual fund managers added them to their funds in order to pick up more yield. And with the Federal Reserve keeping interest rates near 0% for over 4 years and bond yields falling, many managers were being pressured to increase the yield in their funds, and adding Puerto Rico bonds was one way to do this. The other reason for buying Puerto Rico bonds – state tax exemption – comes into play for many state-specific mutual funds. For example, if a mutual fund company wants to offer a fund to N.H. residents that is state-tax exempt, they would be looking to buy mainly N.H. bonds. But since N.H. is a small state that does not issue many bonds, it might be difficult for the manager to find enough bonds to fill the fund, so the manager buys some Puerto Rico bonds, which are also exempt from N.H. state taxes. This provides a basic, simplified explanation of how 70% of U.S. municipal mutual funds came to own Puerto Rico debt.

So why has Puerto Rico been in the news lately?

As we just learned, its economy has been on the downturn for years, so why is it making headlines now? The answer is because of the rating agencies. The two major bond rating agencies, Moody’s and S&P (Standard & Poor’s), both recently downgraded Puerto Rico’s debt from investment-grade (Baa3/BBB-) to non-investment grade (Ba2/BB+), or better known as “junk bonds.” The reasons for the downgrade include many of the issues that we discussed earlier in this article – “years of deficit financing, pension underfunding, budgetary imbalance, along with seven years of economic recession.” As is often the case with the rating agencies, they are behind the curve in terms of their published research, so the bond market has been treating Puerto Rico bonds as “junk bonds” for quite some time, demanding higher yields to compensate for the increased risk. But the reason that this ratings downgrade is significant is because many mutual funds have a policy of owning investment-grade bonds….. and since Puerto Rico is no longer investment-grade, we may see an increase in the amount of Puerto Rico bonds for sale in the bond market, which may lead to a decrease in price, if the supply of bonds outweighs the demand.

So as an investor, what should I do?

Take some time to become familiar with your investments. If you own individual municipal bonds, look at the names of the bonds and determine if any of them are issued by the territory of Puerto Rico or any of its agencies. If you own municipal bond mutual funds or exchange-traded funds (ETFs), find out what percentage of the fund’s holdings are in Puerto Rico bonds. Most mutual funds offer this information somewhere on their website, even though it may take some time to find it. Most prospectuses (the required, formal, legal document that provides details about the fund) or annual reports will offer a state-by-state allocation, which will show you exactly what percentage of the fund is invested in Puerto Rico bonds. Here at Charter Trust Company, our approved mutual funds and ETFs hold less than 4% of their assets in Puerto Rico debt. We have been concerned about the economic situation of Puerto Rico for several years, so we have not been buying individual bonds of the territory since then. There are some situations where these types of bonds may be appropriate for portfolios, but you should make sure that you understand the risks and consequences before buying them.