Puerto Rico shares most of the same business laws with those of the United States mainland. When one thinks about Puerto Rican investments, there are two broad categories to consider: stock in Puerto Rican companies, and tax-free Puerto Rican municipal bonds. There are mutual funds, brokerages, and hedge funds that specialize in these types of investments. The Puerto Rican Investment Act governs investment activities on the island.
A closed-end mutual fund may wish to provide tax-free income to Puerto Rican residents through a variety of instruments. These include securities issued by the Commonwealth of Puerto Rico and its political subdivisions, organizations, agencies, and instrumentalities, Puerto Rico mortgage-backed and asset-backed securities, corporate obligations and preferred stock of Puerto Rico entities. Alternatively, an investment company may package these types of instruments into one or more series of notes. The notes may be fully or partially collateralized, and have differing maturity periods.
The security underwriter is normally incorporated in Puerto Rico. Investors need to compare not only the risks of competing tax-free funds, but also the sales charges attached to each fund. It is not unusual to have sales charges of five percent or greater. One must carefully consider whether the quality of the investment warrants a stiff sales charge. Most investment notes are rated by agencies such as Fitch – the higher the rating, the less chance of default.
The yield on fixed-income securities issued in Puerto Rico can vary for a number of reasons that include:
- Market conditions for municipal bonds and fixed income securities
- The financial condition of the security issuer
- How large is the offering
- The maturity date
- Credit quality and rating
- Income tax rates, including any anticipated changes
Like most securities, ones from Puerto Rico exhibit greater volatility when they have a longer maturity. Volatility shows up as a change in the market value of fixed-income securities. As yields go up, values decline, and vice versa. However, if you hold a fixed-income security until maturity, you will receive the face value, independent of the then-current interest rate level.
Some forms of Puerto Rican municipal obligations are riskier than others. Besides straight debt, you will find various derivative instruments such as zero-coupon bonds and inverse floating-rate obligations. These derivatives are subject to greater volatility, but also may provide a higher return. Another fixed-income investment available in Puerto Rico is mortgage-backed securities. These carry an additional risk that mortgages can be prepaid, which may lower the yield on the securities. Also, as in all parts of the U.S., there is risk of homeowner defaults on mortgage payments, which adversely affect the value of mortgage-backed securities.