US bond fund holders may think that Puerto Rico's fiscal problems aren't of much concern to their portfolios but they may be very surprised at the reality, warns Eric Jacobson of Morningstar FundInvestor.

Puerto Rico has become notorious in recent years for its poor fiscal health. Its problems are many, and they include an overburdened pension system whose funding levels are by far the lowest in any US state or territory. The commonwealth’s overall budget situation doesn't look any better. It continues to run budget deficits and suffers from very high annual debt service requirements.

As Morningstar municipal credit analyst Candice Lee notes, there have been some improvements in recent years, including pension and tax-reform efforts, but they haven't pushed the needle very far, given that the territory's economy has deteriorated while its debt service has grown.

Puerto Rico's problems might seem a world away, but yield-rich bonds issued by the territory sometimes find themselves in places you wouldn't expect. Unlike most other municipal debt, the income from most Puerto Rico bonds isn't taxable at the federal, state, or local level for most US investors. Combined with their rich yields, that feature makes bond issues of the commonwealth particularly appealing to fund managers who have trouble finding enough bonds, or enough income, on their usual stomping grounds.

Indeed, the list of funds with large exposures to Puerto Rico is long—more than 70 funds in Morningstar's database boast at least a 10% exposure to debt issued by the commonwealth. That list, meanwhile, is dominated by a number of single-state muni offerings serving investors in states such as Wisconsin and New York. Of the top 20 funds in Morningstar's database with the most exposure to Puerto Rico, only two have a national mandate.

If you own Fidelity, Vanguard, or T. Rowe Price muni funds, your exposure is minimal. Fidelity Connecticut Municipal Income (FICNX) tops out at 6.35%, while everything from Vanguard and T. Rowe has less than 3% there. On the flip side, many Oppenheimer Rochester muni funds have more than 20% in Puerto Rico, and quite a few Franklin muni funds have between 10% and 20% in Puerto Rico.

Some managers invest in Puerto Rico when they can't find enough opportunities in the local state market. Most fund managers don't want to purchase bonds at just any price, so if a portfolio has more cash than it can put to work in its own state's debt market, it makes sense to seek out bonds from somewhere else, such as a US territory, that will still deliver income without a tax liability. And while Puerto Rico's finances are clearly troubled, it's definitely possible that some managers do their homework and decide that the payouts on the territory's bonds are sufficient compensation for their risks.

Some managers sprinkle Puerto Rico issuance into their portfolios simply to boost yield, though. With agency ratings in the BBB range, the debt of Puerto Rico is technically investment-grade but tends to trade alongside the issuance of high-yield muni sectors, with fat payouts relative to higher-quality debt.

As of Oct. 5, 2012, for example, the subset of Puerto Rico bonds tracked by Barclays carried a yield of roughly 3.9%, while the broader national index was paying out 2.2%. Moreover, a comparison of Morningstar yield data versus fund exposures to Puerto Rico shows a strong correlation between the two, such that funds with larger exposures to the commonwealth are likely to be among the market's higher-yielding portfolios.

None of this is to say that investors are in immediate danger or that Puerto Rico is on the verge of default. Although there are analysts who have speculated that such an event could occur within the next few years, there are also scenarios under which the commonwealth could get its act together and stave off worse trouble. Nearly as important, however, is that even if Puerto Rico's finances deteriorate further without defaulting, the accompanying hits to the territory's credit ratings could easily trigger painful volatility for bond investors.

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Tickers Mentioned: FICNX

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