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 At least two passive ETFs, offered by Van Eck Global and State
Street Global Advisors (SSgA), already have made moves to cut their
exposure to Puerto Rico bonds to avoid being caught with debt that
could be impaired or restructured, portfolio managers said.
Puerto Rico's weighting in some indexes, including the Barclays
Custom High Yield Composite Index, has surged to nearly 30 percent
from less than 5 percent at the start of the year, raising the
dangers for funds that try to track one of the benchmarks. That has
happened because more of the U.S. territory's debt qualified for
inclusion in the indexes after it was slashed to junk by U.S.
ratings agencies.
"There comes a point where our fiduciary responsibility to investors
outweighs how we may follow an index," said Jim Colby, who oversees
the $1.1 billion Market Vectors High Yield Municipal Index ETF for
Van Eck Global.
Fears about Puerto Rico's escalating fiscal woes underscore how
passively run ETFs use a sampling approach to mimic the performance
of an index. They're not obligated to own each of the thousands of
constituents there are sometimes in an index, but instead can select
the ones they want to track it, according to fund disclosures to
investors about their management approach.
Colby said the ETF fund's management team at Van Eck has daily
discussions about how to avoid a hammering if Puerto Rico misses a
bond payment, for example. The fund had 4.3 percent of its assets in
Puerto Rico debt at the end of June.
The fund seeks to replicate the price and yield performance of the
Barclays Custom High Yield Composite Index, which tracks the junk
municipal bond market with a 75 percent weighting in
below-investment grade debt. The ETF is up just 8.6 percent so far
this year, lagging the 10.29 percent advance of its benchmark,
according to Thomson Reuters data.
PRICES REELING
Puerto Rico's chronic budget deficits have spooked the U.S.
municipal bond market, and now fears of a massive restructuring of
its debt have sent its bond prices reeling. The Caribbean island
recently passed legislation that authorizes restructuring of some of
its $73 billion in debt, which could hurt U.S. mutual funds and ETFs,
the biggest holders of the bonds.
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The government-controlled electric authority PREPA is the most
likely candidate to restructure its debt under the new law.
At State Street's $262 million SPDR Nuveen S&P High Yield Municipal
Bond ETF, Puerto Rico bonds make up 5.39 percent of the fund,
compared to an index exposure of 13 percent. That's a significant
decline from the end of June, when Puerto Rico accounted for nearly
8 percent of the fund's net assets, according to fund disclosures.
Dave Mazza, head of research for ETFs at SSgA, the asset management
arm of State Street, said the fund tracks the S&P Municipal Yield
Index, which has more than 30,000 constituents. But the ETF has
chosen Puerto Rico bonds that are backstopped by insurance, showing
how passive funds can sidestep risk.
"So even in regard to an index-tracking product, we have the
flexibility to implement and move and position the portfolio away
from certain areas that may be riskier than others," Mazza said.
Theoretically, he said the fund could have zero exposure to Puerto
Rico if deemed to be appropriate and in the best interest of
shareholders.
"Some investors presume that it’s a very simple, hands off approach,
and that’s not the case at all," Mazza said.
(Reporting By Tim McLaughlin; Editing by Richard Valdmanis and
Martin Howell)
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