By Tim McLaughlin
BOSTON, Oct 30 (Reuters) - U.S. municipal bond funds with at least 5 percent exposure to Puerto Rico debt have experienced an $8.3 billion decline in their net assets in 2013, according to Lipper Inc data.
The 16.3 percent decline from $50.6 billion at the end of 2012 comes as U.S. and state regulators investigate whether the funds adequately disclosed their exposure to Puerto Rico.
Muni bond funds with less than 5 percent exposure have declined only 10 percent to $476.5 billion, according to Lipper.
The Caribbean island's chronic fiscal deficits have rattled a corner of the $3.7 trillion U.S. municipal bond market, which also is absorbing Detroit's fall into bankruptcy.
Municipal bond investors have pulled money from U.S. mutual funds as Puerto Rico bond prices have plummeted. Those two factors have contributed to the decline in net assets.
"They are the scaredy cats of the bond world," said William Larkin, a portfolio manager at Cabot Money Management.
"These are typically wealthy people who are sensitive to changes as they manage their tax problems and rely on tax-exempt muni bonds for their income."
The S&P Municipal Bond Puerto Rico Index is down 15.25 percent this year, a barometer of how falling bond prices have weighed on U.S. mutual funds, among the top buyers of the debt.
Municipal bond funds with at least 5 percent exposure to Puerto Rico have posted a negative return of 5.07 percent this year. Funds with less than 5 percent exposure are off just 0.69 percent, according to Lipper, a unit of Thomson Reuters.
Meanwhile, net assets at some municipal bond funds with Puerto Rico exposure have declined more than 30 percent during the first nine months of this year, according to Lipper.
One of the worst hit has been the $29 million Hancock Horizon Mississippi Tax-Free Income Fund.
Launched in 2011 as a way to invest in Mississippi and its local communities, the fund has about 11 percent of its assets in Puerto Rico bonds, according to Lipper. The fund's net assets have declined 35 percent this year, according to Lipper.
Hancock Horizon did not return telephone calls seeking comment.
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. 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, according to Morningstar.
OppenheimerFunds, a unit of MassMutual Life Insurance Co, has been one of the most aggressive investors in Puerto Rico debt and its portfolio managers make no apologies for their strategy.
They say Puerto Rico's fiscal conditions are better now than they have been in the past six years. They also say investors and media reports have looked past some significant protections provided by Puerto Rico.
Its constitution, for example, gives first priority to debt service on general obligation bonds and guaranteed debt.
"This means that if available general fund revenues were ever insufficient to cover all expenses, debt service on these types of securities would be paid first, before any other disbursement - including pensions or essential services," OppenheimerFunds noted in recent commentary for investors.