In the staid world of municipal bonds, the debt issued by Puerto Rico is in hot demand. For starters, the U.S. territory pays the highest interest rates of any large borrower in the U.S. municipal market. And the interest payments on Puerto Rico bonds are exempt from federal, state, and local taxes for investors in all 50 states. Many muni bond fund managers, looking to juice their yields, have been loading up on Puerto Rico debt. In fact, if you hold a muni fund, there’s a good chance that you own the island’s bonds. That means you’re probably exposed to more risk than you realized.
It’s easy to see why many managers are willing to roll the dice. As of mid-July, the average yield on 10-year general-obligation bonds issued by Puerto Rico was 5.85%, according to Municipal Market Data. For top earners in most states, that equates to at least a 9% yield on a taxable basis. It’s also a hefty 3.2 percentage points higher than the average yield for top-rated municipal debt.
But the yields are fat for a reason. The debt-laden island faces a slew of fiscal problems, including a large budget deficit, a severely underfunded pension system, and an unemployment rate of nearly 14%. Over the past several months, all three major credit-rating agencies have downgraded Puerto Rico bonds to just one notch above “junk” status, with a negative outlook.
Puerto Rico lawmakers recently passed a new budget containing, among other things, tax increases aimed at shoring up the government’s finances. But in July, Moody’s Investor Service warned that the tax hikes could slow any economic recovery, putting even more downward pressure on the island’s credit rating. If the bonds were downgraded to junk status, prices would almost certainly get whacked. “They aren’t for the faint of heart,” says Dan Berger, an analyst at Municipal Market Data.
That hasn’t stopped many pros from piling into them, though. About 75% of all municipal bond funds hold Puerto Rico debt, according to Lipper. In fact, you’ll find Puerto Rico bonds in a lot of unexpected places. For instance, the Wells Fargo Advantage Wisconsin Tax-Free Fund, the Voyageur Delaware Tax-Free Idaho Fund, and the Oppenheimer Rochester Maryland Municipal Fund are just three examples of funds that were recently allocating about 20% or more of their portfolios to Puerto Rico bonds. Each of those three funds makes clear in its marketing materials and prospectus that it may pursue this kind of diversification.
That’s fine — assuming investors understand the risks they’re taking and feel that now is the time to gamble. However, Morgan Stanley chief municipal bond strategist John Dillon now favors general-obligation and revenue bonds with credit ratings of at least mid-A and mid-BBB, respectively, well above most Puerto Rico bonds. At the very least, it pays to look under the hood of any muni fund you’re thinking of buying. You could be surprised at what you find.
A former compensation consultant, Janice Revell has been writing about personal finance since 2000.
This story is from the August 12, 2013 issue of Fortune.
