By Tim McLaughlin
BOSTON (Reuters) - If Hollywood made a western about the municipal bond market, portfolio managers at OppenheimerFunds could be cast as the cowboys brave enough to enter the badlands of credit risk.
Instead of six-shooters, their courage is fortified by a $2 billion line of credit provided by a group of lenders led by Citibank that allows them to weather the occasional sharp declines in their assets.
These days the badlands are distressed Puerto Rican debt, and Oppenheimer's Rochester municipal funds - heavy into the island-territory's bonds - are raising their borrowing amid an investor exodus, U.S. regulatory filings show.
The borrowing is not an entirely bad thing. It can amplify investor income if the money is used to buy more bonds or if interest rates move favorably. The funds also can borrow to avoid selling bonds at distressed prices to meet investor redemption demands, U.S. regulatory filings show.
But more borrowing also be a sign of stress, and added leverage can lead to higher bank fees and interest payments, undercutting investor returns, according to mutual fund analysts.
Rochester's portfolio team, led by Daniel Loughran, declined to comment. But the managers have published commentary this month to defend their contrary stance on Puerto Rico, arguing that the island's fiscal conditions are better now than they have been in the past six years.
The Rochester funds, part of MassMutual Financial Group, are already under the microscope of the top securities regulator in Massachusetts for the way Puerto Rican debt is being handled.
"We are concerned that conservative investors, the types who usually invest in municipal bond funds, may not have been adequately told about the potential risks," Secretary of the Commonwealth William Galvin said. He also is investigating Fidelity Investments and UBS Financial Services (UBSN.VX).
Oppenheimer said its Puerto Rico investments are fully discussed in its public disclosures.
Puerto Rico's nearly $70 billion of outstanding debt is mostly held by U.S. mutual funds. Rochester funds have the highest concentration of Puerto Rico bonds in the industry, according to Lipper.
The island's high jobless rate and shrinking economy have lately sparked worries it could default or require a federal bailout. The S&P Municipal Bond Puerto Rico Index is down 21.6 percent this year, underperforming the 4.1 percent decline on S&P's National AMT-Free Municipal Bond Index.
Sterne Agee analyst Todd L. Hagerman said Puerto Rico needs to carry out an austerity plan, noting how the island has a "dubious history of meeting revenue targets."
Some investors aren't waiting to see what happens. They have pulled nearly $800 million from the Oppenheimer Rochester National Municipals Fund (ORNAX), whose net assets this year have declined 19 percent to $5.5 billion. That's part of a broader $3.1 billion outflow from a group of Rochester funds with about $24 billion in assets, according to Lipper Inc., a unit of Thomson Reuters.
"This is not the kind of volatility that the average investor expects from a municipal bond fund," said Eric Jacobson, a senior analyst at Morningstar Inc.
The average daily loan balance at two of the largest Rochester funds - National Municipals (ORNAX) and Fund Municipals (RMUNX) - was a combined $92 million this summer, up 29 percent from the beginning of the year, fund disclosures show.
More recent figures are not available, but Puerto Rico bond prices have dropped sharply since this summer, putting more pressure on the funds to meet redemptions.
Mutual funds typically have access to these lines of credit but many don't borrow in any meaningful way because it may indicate instability, analysts said. At Oppenheimer's Rochester funds there's no such reservation.
In 2009 - in the midst of the global financial crisis - Rochester's National Municipals and Fund Municipals funds had a combined average daily loan balance that had surged to $1.1 billion. Investors who stayed in the fund during that time required an iron-clad stomach, but were rewarded for sticking around. The fund dropped 48.9 percent in 2008 only to rebound 51.4 percent in 2009.
This year, National Municipals and Fund Municipals are down 8.3 percent and 11.05 percent, respectively.
"Borrowing, or using leverage, is something they've done regardless of the environment to generate a lot of extra income," Jacobson said. "You see this with other funds, but usually not to the degree you see with Oppenheimer."
(Reporting By Tim McLaughlin; Additional reporting by Svea Herbst; Editing by Richard Valdmanis and Leslie Gevirtz)