Puerto Rico’s Lesson For ETF Investors

The commonwealth’s muni bond default highlights ‘political risk.’

Should municipal bond ETF investors be worried about what’s going on with Puerto Rico bonds? Probably not.

Should they be aware of it? Definitely.

While the current news about Puerto Rico’s default on its municipal bonds is not a surprise, it is a good demonstration of what political risk looks like to bondholders.

Political risk refers not to an issuer’s ability to pay, but by its willingness to pay and that it can be recognized not only by a specific repudiation of an obligation, but also by an ongoing unwillingness to do what is necessary to be able to pay. Political risk has generally been more of a concern of investors in emerging market bonds than for municipal bonds.

Credit Ratings And Political Risk

The temptation for an issuer to decide not to pay goes up as financial stress accumulates—and in addition to annual budget challenges, demographic trends can be powerful long-term drivers of economic stress (just as demographics may have been the driver behind boom times too).

Because issuers with greater financial flexibility will have less incentive to resort to political means for solving financial problems, credit ratings can offer a reasonable starting point in looking for possible political risk.

However, lower credit ratings should not in and of themselves suggest higher political risk. General obligation bonds and bonds paid from comingled taxes or revenues may be more vulnerable to political risk than essential service and other revenue bonds. Signs of an increase in political risk can include long-term declining economic or credit trends accompanied by an increase or extension in debt.

With economic growth slow and demographics in some parts of the country turning negative, political risk could quietly increase.

However, most borrowers are serious and diligent in how they manage their debt. Notwithstanding the current attention on Puerto Rico, most of the 60,000 issuers in the muni market will never be in the headlines. Political risk may be increasing, but it should remain a low-probability source of investment risk in the municipal bond market.

Muni ETFs And Political Risk

Because of the very broad diversification, investors in muni ETFs should be much less exposed to political risk than investors in individual bonds. In addition, the index-based portfolio management methodology means that issuers with increasing political risk would likely become ineligible for inclusion in most funds before there is an actual default.

Investors who remain concerned about political risk can take advantage of the daily transparency of ETFs to easily review all of the holdings in their funds.

Possible core holdings could be any of the investment-grade general market (nonstate-specific) muni ETFs with an intermediate average duration (approximately 5.0 to 10.0), such as:

• VanEck Vectors AMT-Free Long Municipal Index ETF (MLN | B-94)
• Deutsche X-trackers Municipal Infrastructure Revenue Bond ETF (RVNU | D-73)
• VanEck Vectors AMT-Free Intermediate Municipal Index ETF (ITM | B-94)
• SPDR Nuveen Barclays Municipal Bond ETF (TFI | B-62)
• iShares National Muni Bond ETF (MUB | B-79)
• Columbia Intermediate Municipal Bond ETF (GMMB | D-46)
• Vanguard Tax-Exempt Bond Index Fund ETF (VTEB | D)
• PowerShares National AMT-Free Municipal Bond Portfolio (PZA | B-59)
• First Trust Managed Municipal ETF (FMB)

For more on fund selection, read my recent piece, “How to Pick the Right Muni Bond ETF.”

Patrick Luby is a fixed-income portfolio strategy specialist and the author of www.IncomeInvestorPerspectives.com. He has helped many of the industry’s best advisors and their investor clients understand and navigate the municipal bond market for many years. This is not a recommendation to buy, sell or hold any of the securities or strategies mentioned. The author does not provide investment, tax, legal or accounting advice. Investors should consult with their own advisor and fully understand their own situation when considering changes to their strategy, tactics or individual investments. Information is based on sources believed to be reliable, but its accuracy is not guaranteed. Additional information is available upon request.