Muni bond funds rocked by big bets on Puerto Rican debt, stirring up memories of 2008.

OppenheimerFunds loses more bond bets

Muni bond funds rocked by big bets on Puerto Rican debt, stirring up memories of 2008.

By Jason Kephart | October 13, 2013 – 12:01 am EST

OppenheimerFunds’ municipal bond funds have been rocked by big bets on Puerto Rican debt, stirring up memories of its Core Bond Fund’s disastrous 2008.

The $125 million Oppenheimer Rochester Virginia Municipal Bond Fund (ORVAX) is down more than 15% this year, ranking it dead last among single-state muni bond funds and second-worst among all muni bond funds. The average single-state muni bond fund is down 5.58%.

The losses could come as a shock to Virginia-based investors in the fund, given that the state isn’t facing any particular head winds.

“When you start getting bond fund losses in the 10% range, you’d better have a looming catastrophe,” said Lee Munson, principal at Portfolio LLC. “Short of a North Korean invasion of Virginia, losing 15% in a Virginia-specific bond fund is probably going to make people very upset.”

The main culprit behind the fund’s underperformance has been its big bet on Puerto Rican bonds, which have tremendously underperformed the broad muni bond market. The S&P Municipal Bond Puerto Rico Index was down 21% year-to-date through last Thursday, 19 percentage points worse than the S&P Municipal Bond Index.

The Virginia fund held 33% of its assets in Puerto Rican debt as of Aug. 31, according to Morningstar Inc., more than any single-state muni bond fund.

The Oppenheimer Rochester North Carolina, Arizona, Massachusetts and Maryland funds are the only other single-state muni bond funds that hold more than 25% of assets in Puerto Rican bonds, according to Morningstar.

The median single-state muni bond fund holds just 2.38% of assets in Puerto Rican bonds.

Each of the funds is down more than 11% year-to-date.

“Municipal bond investors hate losses,” said Melissa Joy, director of investments at the Center for Financial Planning Inc., a registered investment advisory firm. “It’s very challenging when you get double-digit losses in bond funds unless you sought out something that was high-risk and high-reward. You’d have to spend a lot of time communicating with clients about it.”

OppenheimerFunds spokesman Joshua Clarkson declined to make any managers available to comment.

Puerto Rican bonds are used by some single-state bond funds, as they are exempt from state taxes in most states.

More importantly, from a bond fund’s perspective, Puerto Rico bonds carry higher yields because of the risks surrounding the territory’s pension deficits and slow economic growth. That leads to higher yields and potentially higher returns.

“It’s pretty obvious that Puerto Rico is a risky credit, and riskier credits yield more,” said Steven Pikelny, analyst at Morningstar.

“Taking on a lot of Puerto Rican bonds essentially turns a fund into a high-yield state municipal bond fund,” he said. “Investors need to be aware of that.”

This week, Massachusetts securities regulators began looking into whether investors were made aware of the risks in these bond funds. It also sent letters of inquiry to Fidelity Investments and UBS.

This isn’t the first time that OppenheimerFunds bond funds have suffered losses from taking on risky bonds.

In 2008, the Oppenheimer Core Bond Fund (OPIGX) infamously blew up because of its mortgage-related debt and credit default swaps. The fund fell 35% that year, nearly matching the S&P 500’s 37% decline.

The risky bets led to charges by the Securities and Exchange Commission that the firm made misleading statements to its shareholders about the funds. The charges were later settled for $35 million.

Given the black eye that the company earned from that episode, it may come as a surprise that OppenheimerFunds now finds itself in a similar position. Or perhaps not.

“It’s hard to change a culture,” said Mr. Munson, who has used OppenheimerFunds’ high-yield muni bond fund in the past.

“They have a culture of buying things that other people don’t want to touch, then telling themselves it’ll be OK,” he said.

“When it works, it’s great. When it doesn’t, you kind of have to stick with it,” Mr. Munson said.

“That’s not what I want for my clients. It goes back to why you own bonds in the first place,” Mr. Munson said.

“If you own bonds, you’re doing it to reduce risk,” he said. “If you just own it to maximize income, it’s going to come back to haunt you.”