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U.S. mutual funds that loaded up on Puerto Rico bonds, including OppenheimerFunds, are now the target of an investigation by a state securities regulator, who says investors may not have been aware of their exposure to the island's fiscal crisis.
The probe by Massachusetts' top securities regulator could spark other investigations because many other state-specific municipal bond funds include Puerto Rico debt in their portfolios, according to analysts. The bonds are exempt from federal, state and local income taxes in all U.S. states, making them attractive to mutual fund managers across the country.
William Galvin, the Massachusetts Secretary of the Commonwealth, said he is investigating three large fund managers, Fidelity Investments, OppenheimerFunds, a unit of MassMutual Life Insurance and UBS Financial Services , to determine how they sold mutual funds with heavy concentrations of Puerto Rico debt and how they disclosed the risk.
(Read more: No, people won't buy bonds on a default: BlackRock)
"Puerto Rican bonds are like sugar in a bakery product. They are always included. Now the question is just how much and what were investors told," Galvin told Reuters.
The three funds companies were the first to receive inquiry letters from Galvin's office, though other fund companies put Puerto Rico bonds in their mutual funds. Fidelity and UBS declined to comment on Galvin's investigation.
OppenheimerFunds, in a statement, said its Puerto Rico investments are disclosed and discussed at length in the funds' public disclosures. The company also said it is cooperating fully with Galvin's inquiry.
Galvin said the companies have a few weeks to respond on how they disclosed the risks associated with Puerto Rico debt.
Puerto Rico bond prices have been in a free fall amid renewed fears about the island's chronic deficits, free spending and high unemployment. The S&P Municipal Bond Puerto Rico Index is down 19 percent in 2013. The index is badly under-performing the S&P National AMT-Free Municipal Bond Index, which is down only 3.6 percent this year.
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OppenheimerFunds' Rochester municipal bond funds have been among the most aggressive in the industry with their heavy concentration of Puerto Rico debt. The $69 million Oppenheimer Rochester Massachusetts Municipal Fund, for example, has nearly 17 percent of its assets in Puerto Rico debt, according to Lipper, a unit of Thomson Reuters.
Galvin's investigation centers on determining the extent Massachusetts' investors were adequately made aware of the risks associated with their investments, Galvin said in a press release. The debt obligations were typically sold through a mutual fund, he said.
"Puerto Rico is currently on the verge of insolvency and many of its obligations are at or near junk rating, thus the risks associated with its municipal debt obligation are disproportionately high," Galvin said in a statement.