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How A Double Tax-Free Fund Twice Burned Investors

With about 60% of its holdings in Puerto Rican debt, investors in Franklin Resource's "Double Tax-Free Income Fund" are feeling the pinch from that country's debt crisis.

Posted on October 28, 2013, at 1:43 p.m. ET

Investors in the "Franklin Double Tax-Free Income Fund" are learning the hard way about one of the finance world's most basic truths — if an investment sounds too good to be true, it usually is.

The fund aims to take advantage of a special provision that allows municipal bonds to be exempt from state and federal income taxes. As a bonus, since the debt of U.S. territories like Puerto Rico, Guam, and the U.S. Virgin Islands also receives the same exempt status as other states, it invested a large portion of its holdings in Puerto Rican bonds, hence the "double tax-free" part in its name. About 60% of the fund's total invested amount is in Puerto Rican debt.

Only problem is, Puerto Rico is going through a debt crisis.

The island's economy has flagged since 2006 when a tax break for American manufacturers expired and was not renewed. Puerto Rico's unemployment rate hasn't been below 11% since 2008, and it has $70 billion in outstanding debt, about $19,000 per resident and 70% of the island's GDP. That debt now hovers just above junk and is at risk for further downgrades.

As a result, the fund — which would normally be a haven for investors seeking steady income yield, tax advantages, and safety from default — now ranks as one of the riskiest bond fund investments going. About 60% of its holdings are rated BBB (the highest is AAA), meaning they are considered to be just above the minimum investment grade threshold.

Started in 1985, the fund was originally called the "Franklin Puerto Rico Tax-Free Income Fund" and required only a $1,000 minimum investment, making it a viable option for average investors. In its marketing materials, the fund's parent company, Franklin Templeton, said managers took a "conservative, income-oriented approach." Carrie Higgins, one of the fund's managers, added, "We adhere to a conservative, disciplined investment strategy."

A Franklin Resources spokesperson said that the bond was designed for residents of states who wanted to get the tax-free treatment but whose states didn't offer enough debt.

Yet the fund now carries a on- star rating (out of four) from Morningstar and has underperformed 91% of all comparable funds in the last 10 years and 99% in the last year. This year, its net asset value for its A shares has fallen over 12%, and its total returns are down 18% for the year. It now has just $461 million in assets, compared with almost $900 million in July 2012.

Although it closed itself off to new investments in August of last year, if you hypothetically put in $10,000 at the beginning of this year, your initial investment would be worth just $8,732.

Franklin Templeton is not alone when it comes to investing in Puerto Rican debt, of course. About 75% of municipal bond funds, which pool together a variety of bonds in a mutual fund that individuals investors buy into, hold some Puerto Rican sovereign debt.

"Because it's a U.S. territory, Puerto Rico has special tax status," said Eric Jacobson, an analyst at Morningstar. "Other states and municipalities do not tax the income that you earn from its bonds, and so it makes it a particularly good substitute."

And since many states and municipalities do not tax the income its residents earn from its debt, big investment firms like Franklin Resources set up special funds designed to reduce taxes. So, for instance, if you live in Georgia, you can buy the Georgia Tax-Free Income Fund, where, according to Franklin Resources, 80% of the fund invested in bonds will be exempt from Georgia state income taxes (part of that is $31 million in Puerto Rican debt).

As a whole, Franklin Templeton has $845 billion in assets under management and $72.4 billion in "tax-free" bond funds.

In a move that could spell trouble for Franklin Templeton, last week, The Bond Buyer, an industry publication, reported that the Securities and Exchange Commission was conducting examinations of funds with investments in Puerto Rican debt.

A Franklin Resources spokesperson told BuzzFeed that the company had no comment on the SEC examinations.

But, in a video posted to Franklin Templeton's website, the co-director of its municipal bond department, Rafael Costa, said that "Puerto Rican bonds have been oversold" and acknowledged the island's long recession, high unemployment, and continuing budget deficits, which have lead rating agencies to rate Puerto Rico's debt just above junk.

He also said he was encouraged by recent pension and tax reform, and that "while we feel Puerto Rico is facing a difficult situation, we feel that their bonds are being unjustly punished in the markets."

According to Morningstar's Jacobson, however, "The really tricky thing with the Franklin fund is that it's always been known that it was highly concentrated. People have been conditioned to take that concentration risk because they're so focused on saving taxes, there are times when people put their tax advantages ahead of their investment thesis."