These ETFs Hold Puerto Rico Bonds

As I asked last week in my piece, "Puerto Rico's Lesson For ETF Investors," 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.

And to increase that awareness, we thought we would take a look at ETFs listed in the U.S. that have exposure to Puerto Rican municipal bonds.

Because most muni ETFs are managed to follow indexes that do not permit inclusion of noninvestment- grade bonds, only a handful of funds have exposure to Puerto Rico bond issuers.

Whether a fund has exposure to Puerto Rico will be a function of the rules that govern the index used by the fund—it is not based on the discretion of the manager, whose job is to track the index as closely as possible. The indexes are managed by independent third-party providers such as S&P Dow Jones Indices, Barclays or others.

Sources: FactSet Research Systems, Inc., with additional data from manager websites.

Different Index Rules

For example, the index used by the iShares National Muni Bond ETF (MUB | B-79) specifically excludes "bonds issued by U.S. territories, including Puerto Rico." Meanwhile, the PowerShares New York AMT-Free Municipal Bond Portfolio (PZT | C-51) "tracks an index of investment-grade tax-exempt debt issued by New York or Puerto Rico with at least 15 years remaining to maturity."

In the case of PZT, if any bond falls below investment grade (as defined by the index methodology), it would become ineligible to be held in the portfolio and would be sold by the manager.

While it may appear that the VanEck Vectors Pre-Refunded Municipal Index ETF (PRB | C-30) has a small exposure to Puerto Rico, the fund follows an index that comprises "pre-refunded and escrowed-to-maturity bonds (ETMs) with underlying collateral comprised solely of U.S. Treasuries and U.S. Treasury-issued State and Local Government Series bonds (SLGs)."

According to the MSRB Glossary of Municipal Security Terms, "Typically, such refunded bonds are secured solely by an escrow funded with the proceeds of the refunding bonds." In such a case, the credit risk exposure would not be to the Puerto Rico-based issuer, but to the collateral held in the escrow accounts.

Why You Don't Need To Sell

So should investors holding a muni ETF with Puerto Rico exposure consider selling?

Not necessarily. The low-cost index-based portfolio management methodology available with ETFs means that investors can assemble their muni ETF portfolio based on exposure to the factors (such as maturity/duration or credit risk) they want while reducing the emotional biases that can influence a self-directed portfolio.

If the ETF was appropriate before, and there has been no change in the investor's objectives, consider whether a desire to sell is an emotional reaction to recent headlines, and if so, it may not be appropriate to sell. ("How to Pick the Right Muni ETF" may be of help as well.)

Keep in mind too that because ETF portfolios are disclosed to the market at the end of each day, current ETF prices will reflect the prevailing market prices for all of the underlying bonds in the portfolio.

Patrick Luby is a fixed-income portfolio strategy specialist who has helped many of the industry's best advisors and their investor clients understand and navigate the municipal bond market for many years. He is the author of www.IncomeInvestorPerspectives.com and has written a number of muni ETF articles for ETF.com. Click here to go to his author page.

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.