Fitch: New Puerto Rico Fund Regulations Modest Credit Positive

The new Puerto Rico Investment Companies Act of 2013 makes several improvements to the regulatory oversight of the island's $11billion-plus fund industry that are modestly credit positive for rated short- and medium-term notes issued by Puerto Rican closed-end funds (PR CEFs), according to Fitch Ratings.

The act revamps compliance and governance rules, allows for greater diversification outside of Puerto Rico, establishes formal fund leverage limits, creates a new type of tax-advantaged structure, and mandates all rulings by the Commissioner of Financial Institutions be made public going forward, according to local law firm L??pez S??nchez Pirillo & Hymovitz, which specializes in this area.

Existing funds are for the most part grandfathered in the Investment Companies Act of Puerto Rico of 1954 (Old Law), except for having to comply with new rules with respect to affiliate transactions, tighter governance over fund directors and officers, and uniformity over repurchasing fund stock from investors. These changes closer align local investment companies with protections already in place for U.S. mutual funds under the U.S. Investment Company Act of 1940, as amended. Moreover, shareholder approval is needed to convert existing funds to the new law, which may prove challenging.

Under the Old Law, Puerto Rico investment companies invest mainly in municipal debt issued by the island's government, in line with a 67% minimum investment requirement. The new law notably lowers the Puerto Rico investment requirement to 20% for Puerto Rico investment companies which invest in municipal debt and eliminates it completely for Puerto Rico investment companies that do not invest in municipal debt, which should lead to greater diversification of closed-end fund portfolios. To date, Fitch's ratings of debt issued by PR CEFs were constrained in part by the concentrated exposure to Puerto Rico obligors. The changes are intended to improve retail confidence in new Puerto Rico mutual funds, while at the same time allowing fund managers to invest in local equity of Puerto Rico companies.

The new law also formalizes leverage limits to 50% of assets for traditional leveraged funds, and allows an additional 5% cushion when authorized by the Puerto Rico. Commissioner of Financial Institutions. In case of unleveraged funds, only the latter 5% is applicable. All except one Fitch-rated Puerto Rico fund already operate within these limits, as per filed prospectus guidelines.

One major addition to the new law is the creation of Exempt Investment Trusts (EITs) to incentivize domestic capital investment in equity of local companies. EITs will enjoy full tax exemption, require minimal start-up capital, and are able to operate with few limits on leverage and asset diversification as long as they generate at least 75% of gross income from eligible activities and have at least 60% of the market value of assets represented by income from eligible sources, as provided in the new law.

Fitch believes that one negative consequence of the new law may be the divestiture of local municipal bonds by existing funds choosing to convert to the new 20% framework. This could put further pressure on Puerto Rican entities that are under credit pressure and seeking to refinance maturing obligations.

Additional information is available on www.fitchratings.com.

The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article, which may include hyperlinks to companies and current ratings, can be accessed at www.fitchratings.com. All opinions expressed are those of Fitch Ratings.

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