Municipal bond funds will survive a Puerto Rico shakeout
Barron’s had a recent story, “Puerto Rico’s Debt Woes Could Spread,” that says, “As mid-year statements go out, muni-fund redemptions could force selling of other credits.” Barron’s author Randall Forsyth wrote:
But the effects of legislation to allow restructuring of the debt of the [Puerto Rico] so-called public corporations continue to ripple through the municipal bond market. Thus far, those ripples have been contained, with little spillover into the broader muni market.
That could change, however, when holders of tax-exempt bond funds — especially the high-yield variety — get their June 30 statements. How these individual investors react to the funds’ declines from their exposure to Puerto Rico debt could hit the broader muni market if funds are forced to liquidate bonds to meet shareholder redemptions.
Mutual funds have three ways to meet investor redemptions; 1) Sell bonds 2) Use cash reserves or 3) Draw on established lines of credit with banks. We have only glimpses of data to determine which of these strategies are being used in Puerto Rico. Some selling has been reported by market participants.
We can see how much exposure municipal bond mutual funds have to Puerto Rico debt. The Federal Reserve said that mutual funds held $621 billion of muni bonds in the first quarter of 2014. Morningstar data says that muni funds held $12 billion in Puerto Rico bonds in the same period. Overall mutual funds held about 2 percent of their assets in Puerto Rico debt.
Morningstar data says that high yield municipal bond funds had $52.7 billion of assets and $2.7 billion of Puerto Rico bonds or 4.9 percent as of March 31, 2014.
One important unknown is how many Puerto Rico bonds in muni funds are insured. We know that about $6 billion of Puerto Rico bonds are insured by Assured Guaranty, MBIA’s National Public Finance and others, but don’t have a view into specific mutual fund holdings.
— Gretchen Kennedy (@gretkennedy) July 9, 2014
Municipal Market Advisors reported that mutual funds are having big outflows, but we don’t know exactly how big they are or if they are balanced by new money inflows.
— Muni Market Advisors (@Muni_Mkt_Advis) July 8, 2014
Meanwhile, fund managers John Miller and Tony Rodriguez at Nuveen Asset Management wrote on July 7 that they saw no general muni selloff from Puerto Rico:
In our opinion, the sell-off was not due to the downgrade of several Puerto Rico credits and the subsequent credit-related sell off. Puerto Rico analysis was contained to credits of the island itself with no generalizations to the broader municipal market. We saw no major general municipal selling pressure after the Puerto Rico news.
Bloomberg ran a story Tuesday about the the $300.4 million Franklin Double Tax-Free Income Fund (FPRTX) hitting a 29-year low. But this Franklin fund is an extreme outlier, holding about 69 percent in Puerto Rico debt. Here are the other mutual funds with the heaviest exposure to Puerto Rico as of March 31, 2014, according to Morningstar:
These funds could likely see more selling pressure from investor redemptions.
It’s possible that we are seeing a reallocation by investors around Puerto Rico; not a massive wave of selling. More from Nuveen:
Supply/demand dynamics should bode well for municipals. The 30-day new issue calendar is a mere $4.9 billion with a large amount of July 1 coupon money still to be invested. Mutual fund flows were positive last week at $19 million.
High yield municipal funds saw inflows for the 26th consecutive week, but attracted just $5.7 million. Year-to-date flows are $5.24 billion. High yield credit spreads widened sharply, almost entirely due to falling Puerto Rico bond prices, weakness in tobacco bond prices and in sympathy with funds heavy in both. All eyes are focused on the secondary market, especially the liquidity needs of funds heavy in Puerto Rico and tobacco. Excluding Puerto Rico, credit spreads for high yield municipals are nearly at June 30, 2013, levels.
Will Puerto Rico create a systemic event for muniland? I don’t think so, but stay tuned.