BOSTON (Reuters) - Massachusetts' top securities regulator said on Wednesday he may ask the U.S. Securities and Exchange Commission to change a rule allowing money managers to put high concentrations of troubled Puerto Rico debt in state-specific municipal bond funds.
A major issuer on the United States municipal bond market, Puerto Rico has $70 billion in outstanding debt that has been very popular with investors and fund managers because it is exempt from federal, state and local taxes.
But with concerns mounting about the island territory's economic health, investors are starting to fret about its ability to pay its debts. The S&P Municipal Bond Puerto Rico Index is down 17 percent in 2013.
"As I look deeper into whether investors were misled on the risks of these bond funds, there might be an opportunity to raise it with federal regulators," Massachusetts Secretary of the Commonwealth William Galvin told Reuters in a telephone interview.
His office opened an investigation two weeks ago into whether investors in Massachusetts were adequately informed about the potential risks associated with Puerto Rico debt in municipal bond mutual funds.
He initially targeted Fidelity Investments, OppenheimerFunds - a unit of MassMutual Life Insurance Co - and UBS Financial Services with letters of inquiry.
"We haven't sent out any more requests for information yet, but we could," Galvin said. "By now everyone acknowledges that there is an issue with Puerto Rico."
Puerto Rico debt represents nearly 2 percent of the $3.7 trillion U.S. municipal bond market.
About 180 funds representing more than $100 billion in net assets have weightings of 5 percent or more in Puerto Rico bonds, Morningstar analyst Eric Jacobson said in a recent research report.
Investors pulled more than $6.5 billion from municipal bond funds in September, with at least $500 million coming out of the 20 funds with the greatest exposure to Puerto Rico.
But analysts say investors are not often aware of Puerto Rico's weighting in a state-specific municipal bond funds such as the John Hancock Massachusetts Tax-Free Income Fund. That fund and many other state-named funds have had more than 10 percent of their assets in Puerto Rican debt.
The Securities and Exchange Commission's fund naming rules allow single-state municipal bond funds to own not only their state-issued debt, but also any tax-exempt bonds. Because Puerto Rican debt is tax exempt in every state, it has become a popular option for fund managers seeking to diversify and generate income from yields that are typically higher than debt of the states for which the funds are named.
Municipal Market Advisors, a top municipal bond research firm, said pressure brought by Galvin and other regulators may lead states to tighten investment rules for their single state funds.
While Galvin's investigation is still in its early stages, he said he could move quickly to appeal for big changes.
Galvin noted that there are plenty of loopholes that fund managers could exploit in stocking their municipal bond funds with riskier securities, like Puerto Rico's. But states are often prevented from acting independently on setting rules on exactly what goes into the funds because they are regulated by the Securities and Exchange Commission.
Galvin has a reputation in Massachusetts and on Wall Street as a tough regulator who has taken on mutual funds over market timing and won big settlements against Wall Street banks over improperly disclosed research. He has often led federal regulators in past probes.
Reporting by Svea Herbst-Bayliss; Editing by Richard Valdmanis and Dan Grebler