The tide is out in Puerto Rico, giving investors a peek at which municipal debt holders have been swimming naked. For some U.S. tax-free mutual funds, it’s not a pretty sight.
Take the $52.1 million Oppenheimer Rochester Maryland Municipal Fund and the $111.9 million Oppenheimer Rochester Virginia Municipal Fund. According to Chicago-based Morningstar, the funds had 42.7 percent and 37.5 percent of their respective portfolios in Puerto Rican government debt as of the end of September, nearly two months after the commonwealth defaulted on some interest rate payments. Morningstar made its calculations based on bond issues with Puerto Rico in their names, using the funds’ latest disclosures.
The two funds’ big Puerto Rican debt holdings speak to managers’ hunger for yield in a low-interest-rate environment. The island’s municipal bonds can sport coupons of 7 percent or more. More important, the Caribbean exposure raises questions about the marketing of funds — and the U.S. Securities and Exchange Commission’s stance on what some see as egregiously misleading fund names. After all, if an investor buys a fund that bills itself as targeting, say, Virginia munis, shouldn’t the fund be required to stick to its advertised objective?
The SEC adopted Rule 35d-1 in 2001 to address the matter. Generally, if a fund’s name refers to a specific type of security — say, convertible bonds or Japanese stocks — the fund is required to invest at least 80 percent of its assets in the category. The rule goes for muni funds too: They must generally meet the threshold by investing 80 percent of their net assets in bond issues that are tax-free at the state and federal level.
Of course, Oppenheimer’s Maryland and Virginia muni funds both hold well under 80 percent of net assets in their indicated states’ bonds. They are not alone. The $424.8 million Oppenheimer Rochester New Jersey Municipal Fund, the $3 billion Oppenheimer Rochester Limited Term New York Municipal Fund and the $51.6 million Oppenheimer Rochester Arizona Municipal Fund all had less than 75 percent of their assets in their respective states’ debt, according to recent filings.
Part of the blame rests on Rule 35d-1, which has large loopholes. For example, the 80 percent threshold applies during “normal circumstances.” Funds are allowed to fall below it during times of big cash inflows or outflows — or simply to take a defensive position. Also, the 80 percent minimum applies to investments and thus doesn’t take into account subsequent gains, losses or sales. So a fund can dip below that level because of a variety of market factors such as redemptions — of which there have been plenty in 2015, according to Morningstar estimates.
Rule 35d-1 allows all funds to fall below the 80 percent investment threshold if they notify fund shareholders 60 days prior to a change in their policy. If a single-state muni fund chooses to invest in out-of-state securities, it must say so in its prospectus. Hence, the disclosure that appears in various prospectuses of the Oppenheimer Rochester products, such as that of the Virginia vehicle: “The Fund also invests in the obligations of the governments of U.S. territories, commonwealths and possessions such as Puerto Rico, the U.S. Virgin Islands, Guam, or the Northern Mariana Islands to the extent such obligations are exempt from state income taxes. These investments also are considered to be ‘Virginia municipal securities’ for purposes of this prospectus.”
Which brings us to the biggest loophole of all. For determining whether an investment falls into the 80 percent bucket of state tax-free securities, it is the double tax-exempt status of a bond or other obligation that matters, not the location of its issuer. Since the bonds of all U.S. territories and commonwealths are tax-free at the state level nationwide, these can be considered to be state municipals for the purposes of the 80 percent threshold. Accordingly, a single-state muni fund theoretically doesn’t even need to invest at all in the bonds of the state in its name. The SEC’s rationale is spelled out in a footnote to the rule. “Investors are generally more interested in the tax-exempt nature of an issuer’s distributions than the issuer’s location,” it reads.
OppenheimerFunds, which oversees the single-state muni funds in question, says its products are following the letter of the regulation. “The Oppenheimer Rochester single-state funds are in compliance with the SEC’s names rule,” says spokeswoman Kimberly Weinrick. “The Rochester single-state funds prominently disclose that they invest in the securities issued by various U.S. territories, including Puerto Rico.”
It’s no surprise, however, that some view this loophole as inconsistent with the aim of the rule. “The SEC’s position that a Virginia tax-free fund can invest 100 percent of its assets in Puerto Rico securities speaks for itself,” says Mercer Bullard, an associate professor of the University of Mississippi School of Law and a former assistant chief counsel at the commission. “The most misleading name here is the SEC calling itself an investor advocate.” SEC spokesman John Nester declined to comment on the rule’s application.
The Oppenheimer Rochester funds are big holders of Puerto Rican debt across the board. Of the top 20 muni bond funds ranked by Puerto Rican debt exposure, 17 are from the family, according to Morningstar, and most of them are single-state. The market value of its total Puerto Rican debt holdings was $3.8 billion out of a total of $23.5 billion.
It bears noting that Oppenheimer isn’t the only asset manager scooping up Puerto Rican bonds for its single-state, mainland tax-free funds. The $116.9 million Eaton Vance Oregon Municipal Income Fund held 9 percent in Puerto Rican bonds as of month-end August, and the $157.6 million Wells Fargo Advantage Wisconsin Tax-Free Fund held 9.2 percent, according to Morningstar.
“Understanding what these funds can invest in is really important,” says Elizabeth Foos, a senior analyst at Morningstar. “When you start seeing the single-state funds with these types of weightings, it’s definitely a question for us.” Nevertheless, she argues out that some single-state muni funds may have trouble diversifying their portfolios sufficiently, if they were forced to focus solely on their own particular state, especially if there is a scarcity of issues.
There are some important practical considerations too, says professor Bullard, a founder of advocacy group Fund Democracy. “How do you know how a fund has performed unless you benchmark it?” he asks, pointing out that the performance of a fund like the Oppenheimer Rochester Virginia Municipal is difficult to gauge. “You are not really a Virginia fund.”
Not surprisingly, most of the Puerto Rico–heavy muni bond funds have trailed a Barclays muni bond index this year. Whether that means a disgruntled fund investor or two might want to complain about that in court is anybody’s guess. If they do, some investment firms may have to start worrying more about lawsuits than swimsuits.
