Puerto Rico's debt woes hit muni bond funds

• Like states%2C Puerto Rico can%27t file for bankruptcy
• Puerto Rican debt may need to be restructured
• U.S. unlikely to step in

While the U.S. struggles with its debt limit, Puerto Rico faces its own debt issues -- and that worries some investors.

Like states, Puerto Rico, a U.S. territory, can't file for bankruptcy. But it has some $70 billion in tax-free municipal bonds outstanding, far more than Detroit's $18 billion, currently the largest municipal bankruptcy on record.

"The situation has a lot of fiscal challenges, and the government is trying to meet them, but they're in a pretty big hole and it's going to take a lot of hard work to get out of it," says Hugh McGuirk, head of municipal fixed income at T. Rowe Price, the Baltimore mutual fund company.

Because of their risk, and because there's such a large volume outstanding, some of Puerto Rico's muni bonds offer high yields. For example, a Puerto Rico Commonwealth bond maturing in 2018 yields 9.4%, according to FINRA, the securities markets self-regulatory agency.

Yields like those are tempting for bond fund managers, especially since five-year, high-quality muni bonds yield 1.24%, according to Bloomberg., About 70% of all muni bond funds have Puerto Rican bonds in their portfolios, says Morningstar, the Chicago investment trackers.

According to law, Puerto Rico's bonds are tax-free in any state of the U.S.

McGuirk isn't sure that the government will step in if there's a problem with Puerto Rico's bond payments. "I'm skeptical that there's that kind of significant support in Washington to prop up the bonds," he says. Those who bought the bonds thinking the U.S. will bail out Puerto Rico will need to re-evaluate that, he says.

According to Morningstar, some muni funds have significant exposure to Puerto Rico:

• Franklin Double Tax-Free Income A (ticker: FPRTX) has 65% of its holdings in Puerto Rican obligations. The fund is down 14.5% this year, including reinvested interest.

• Oppenheimer Rochester VA Municipal A (ORVAX), has 33.3% of its holdings in Puerto Rico bonds. It's down 12.9% this year.

• Oppenheimer Pennsylvania Municipal A, 24.7% in Puerto Rico bonds, down 8.6% this year.

Unlike Greece, Puerto Rico has fairly little short-term debt, which means that there's not as much risk of it hitting a near-term financing block, where investors refuse to roll over their short-term holdings, McGuirk says. "They don't have a drop-dead financing date like Greece did," he says.

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