Most Americans think of Puerto Rico and the U.S. Virgin Islands as places to take a Caribbean vacation. But these American territories, along with farther-afield Guam and American Samoa, have financing needs, like any other independent state. That means they must issue bonds. And, as it turns out, their munis can be very useful for fixed-income investors on the mainland. This month, when many states' tax-free bonds are maturing or being called and when new issues are scarce, it may pay to go bond shopping in the islands.
The appeal of bonds from U.S. territories derives from their special tax status: They are always exempt from federal, state, and local taxes
--no matter where you live in the U.S. Their credit markets are also remarkably stable--especially Puerto Rico, which dwarfs the other territories in the volume of bonds issued. Puerto Rican bonds are always in demand, since investors all over the U.S. can use them in their tax-free portfolios. Even the proliferating single-state mutual funds regularly buy Puerto Rican debt for diversification, and this helps keep the market buoyant. "Though investing in Puerto Rico sounds obscure, it is not obscure at all," says Sheila Amoroso, portfolio manager of Franklin Puerto Rico Tax-Free Income Fund, the only U.S.-territory mutual fund. The fund, which also holds bonds from Guam and the Virgin Islands, has returned an average of 7.53% for the past five years.
Almost any investor with a portfolio of tax-free bonds may want to consider Puerto Rico's debt. For one thing, the bonds add diversification. They are also very liquid. "They are part of a conservative approach" to tax-free investing, says John Flahive, vice-president and head of the municipal-bond department at Mellon Private Asset Management in Boston.
MOVABLE BEAST. The downside is that Puerto Rico's debt doesn't come cheap. You'll probably have to give up about 10 basis points of yield to buy its top-rated paper, compared with other AAA-rated munis. But it's worth it, says Flahive. "To have the stability and the diversification and give up some additional yield seems very prudent to us," he says. Besides, even if you pay a bit more, you should be able to sell Puerto Rican paper for at least what you paid for it, since there is a strong secondary market and the price should remain above other issues.
Bonds from U.S. territories can prove particularly handy in a few specific situations. For example, young executives who expect to be transferred in a few years can rest assured that their munis will continue to be tax-free, no matter what state they move to. When structuring portfolios to meet future college costs, Peter Frisch, a financial adviser at Prudential Securities in Boston, has used zero-coupon bonds from Puerto Rico in combination with growth stocks for clients who expect to move around while climbing the corporate ladder.
Puerto Rico's bonds are also attractive to people who live in the handful of states, such as Illinois, Iowa, and Oklahoma, that tax most of their homegrown debt. For example, an Oklahoma resident purchasing AA-rated Oklahoma City bonds yielding 4.5% would have to pay 5% of that in state tax, bringing the aftertax yield down to 4.27%. That person could buy a BAA-rated bond from Puerto Rico that yield 4.5% tax-free and come out ahead. That's not necessarily the best option, however, since you may be better off going to a state other than the one you live in, finding a cheaper bond, and paying the state tax, says Andrew Goldstein, a bond trader at Stoever Glass in New York.
In general, you should consider bonds from U.S. territories only after shopping around at home--and then you would be well advised to stick with top-rated insured bonds, says Patrick Retzer, director of fixed-income at Heartland Funds. "If an investor has an issue in their state they are familiar with, I would lean toward buying that," he says, mainly because it is easier to monitor.
But with local bonds sometimes hard to come by and with cash coming in from holdings that have matured or that have been called, you may find that Puerto Rico or the Virgin Islands could have a place in your tax-free portfolio, even if not in your vacation plans.
When to Buy Munis From U.S. Territories
-- If you expect to move to another state in a few years
-- If your state doesn't exempt its own bonds from state and local taxes
-- If the kind of bond you're looking for isn't available at home
-- If you want to diversify a portfolio of local bonds