What does this mean for municipal bond investors?Christopher Alwine, head of Vanguard Municipal Bond Group, said that although the situation in Puerto Rico and the implementation of PROMESA will create headlines for the foreseeable future, any resulting price volatility will likely be limited to Puerto Rico bonds. There was light trading and minimal price movement in Puerto Rico bonds as the market digested the details of the July 1 default.
“We don’t see this as a seismic event,” Alwine said. “Our funds have very little exposure to Puerto Rico’s debt issues, and the impact of Puerto Rico’s default on the broader municipal bond market is likely to be negligible.”
Although the $70 billion in Puerto Rico bonds is a large amount in nominal terms, it represents only a small fraction of the $3.7 trillion in the municipal bond market. “Overall, the credit quality of most municipalities is improving as they continue to benefit from economic recovery,” Alwine said.
Additionally, Puerto Rico’s economic troubles have been mounting for years and, to a large extent, the market has priced in the likelihood of a default of this magnitude by the territory. Its cost to borrow has risen with each new bond issue. The 2014 issue of its general obligation bonds, which was the last time bonds were sold in a public offering is currently yielding about 12% a year.
Puerto Rico’s bonds have been rated below investment-grade1 since early 2014. They are currently rated CC, D, and Caa3 by Standard & Poor’s2, Fitch, and Moody’s, respectively, indicating a high level of distress or default. As a result, the bonds have largely changed hands from traditional municipal bond investors to those seeking riskier investments in the pursuit of higher yields, such as hedge funds.
Impact on Vanguard funds is smallVanguard municipal bond funds have little exposure to Puerto Rico debt instruments. Of the approximately $134 billion in Vanguard’s municipal bond fund assets, as of May 31, 2016, only 0.10% was invested in Puerto Rico debt.
Of this exposure, only Vanguard High-Yield Tax-Exempt Fund holds uninsured Puerto Rico bonds. All other fund holdings are insured by firms able to make timely payments on claims if the situation warrants.3 Insured Puerto Rico bonds are held in Vanguard Intermediate-Term Tax-Exempt Fund, Vanguard Long-Term Tax-Exempt Fund, Vanguard New Jersey Long-Term Tax-Exempt Fund, and Vanguard New York Long-Term Tax-Exempt Fund.
Ongoing monitoring and independent assessmentVanguard has more than 20 fixed income credit research analysts who continually evaluate the credit situation of Puerto Rico and other issuers. Our municipal bond team works closely with our taxable credit research team to form an independent view of the creditworthiness of the insurers of securities we hold, or are considering holding, in our funds.
1 Investment-grade fixed income securities are those rated the equivalent of Baa3 and above by Moody’s.
2 On July 1, 2016, Standard & Poor’s issued a press release indicating that it expected to lower its rating to D on July 5, 2016.
3 Municipal bond insurance, which is usually purchased by the bond issuer from a private, nongovernmental insurance company, provides an unconditional and irrevocable guarantee that the insured bond’s principal and interest will be paid when due. Insurance does not guarantee the price of the bond or the share price of any fund.Notes:
All investing is subject to risk, including the possible loss of the money you invest.
Bond funds are subject to the risk that an issuer will fail to make payments on time and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments.
Funds that concentrate on a relatively narrow market sector face the risk of higher share-price volatility.
High-yield bonds generally have medium- and lower-range credit-quality ratings and are therefore subject to a higher level of credit risk than bonds with higher credit-quality ratings.