Mutual Funds

Redemptions force US mutual funds to unload Puerto Rico debt

A vacant building in the Santurce neighborhood of San Juan, Puerto Rico.
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U.S. mutual funds with heavy exposure to Puerto Rico bonds have sold off some of the cash-strapped island's debt to meet investor redemption demands, taking heavy losses after a year-long slide in prices.

The sellers included some of Puerto Rico's most bullish U.S. mutual fund investors. Some of the funds run by OppenheimerFunds, a vocal supporter of the territory's recent financial improvements, have sold Puerto Rico debt, according to analysts and public filings.

But Oppenheimer's Rochester funds combined have been net buyers of Puerto Rico bonds over the past few months as its research continues to show that Puerto Rico will honor its debt obligations in full, company spokeswoman Kaitlyn Downing said.

Funds with less exposure aren't likely to unload their Puerto Rico debt at fire sale prices, said Daniel Hanson, an analyst at Height Securities LLC. They can afford to hold tight and ride out the storm.

Still, mutual funds have found willing buyers in more risk-prone hedge funds, such as Meehan Combs LP and Maglan Capital. Distressed debt funds run by Marathon Asset Management LP and Stone Lion Capital Partners LP also have shown interest in Puerto Rico's bonds, analysts said.

Puerto Rico and its agencies have about $70 billion in debt outstanding, and much of it is held by U.S. mutual funds. Its bonds are appealing because they are tax-exempt in every U.S. state, and the yields offer high returns to investors willing to stomach the uncertainty.

(Read more: Moody's downgrades Puerto Rico GO debt rating two notches to 'junk' status)

A darkening outlook for Puerto Rico's finances has made investors nervous about a potential default. Standard & Poors cut Puerto Rico's credit rating to junk status on Tuesday, and Fitch warned in November it could do the same.

Before the S&P's move, mutual funds run by Vanguard Group and BlackRock Inc disclosed this past week they had eliminated what they described as small positions in the territory late last year, regulatory filings show.

Gross doesn't think Puerto Rico will default

The top 10 U.S. mutual funds with the greatest exposure to Puerto Rico have been hit with nearly $3 billion in net outflows over the past year, according to Morningstar Inc. data, amounting to about a quarter of the funds' combined net assets.

The $363 million Franklin Double-Tax Free Income Fund , which has about 60 percent of its holdings in Puerto Rico debt, recently sold nearly $64 million worth of bonds, according to data from Thomson Reuters' Lipper service. At least half of those sales included Puerto Rico bonds as the fund has experienced $277 million in outflows in the past year, according to Morningstar and Lipper data.

The Franklin fund, run by Franklin Resources Inc, is grappling with a mandate geared toward investing at least 80 percent of its assets in tax-free bonds issued by U.S. territories. "Given that Puerto Rico issues the vast majority of bonds among these territories, Puerto Rico currently represents the majority of the fund's investments," Franklin spokeswoman Stacey Johnston Coleman said.

Municipal Market Advisors Inc., an independent municipal bond research firm, said in a note to clients that Puerto Rico's downgrade could re-ignite the sort of heavy investor outflows witnessed last year when the S&P Municipal Bond Puerto Rico Index fell nearly 21 percent.

"Funds may need to turn to selling things like tobacco (bonds) in the near term to raise cash, further exacerbating the market condition," MMA said.

Funds meet redemptions typically by selling portfolio assets or by borrowing from a bank credit line. Sometimes they are forced to unload assets they would prefer not to sell.

OppenheimerFunds, a unit of insurer MassMutual Financial Group, has nine funds of the top 10 funds with the greatest exposure to Puerto Rico, according to Morningstar. The funds also have been the most bullish about Puerto Rico, saying that negative headlines in the press don't take into account the island's many financial improvements.

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OppenheimerFunds' Puerto Rico holdings total about $5.1 billion, a decline of about 15 percent, or $900 million, over the past year, according to fund disclosures.

The $6.2 billion Oppenheimer Rochester Municipals Mutual Fund, for example, sold $51 million worth of a Puerto Rico sales tax revenue bond that matures in 2054, according to Lipper data for the fourth quarter. The fund's net outflows over the past year have totaled $1.2 billion.