The Franklin Templeton Double-Tax Free Income Fund Is A Highly Risky Bond Fund

| About: Franklin Double (FPRTX)

Summary

Investors typically assume that municipal bond funds are very safe investments but this is not always the case.

Nearly 60% of the holdings of the Franklin Templeton Double Tax-Free Income Fund consist of Puerto Rican municipal bonds.

According to the wisdom of the market, the Puerto Rican government has a higher chance of defaulting on its debt than Greece.

The Puerto Rican government-owned electric utility also has a high probability of defaulting. These bonds also likely make up a significant portion of the fund.

The majority of the bond fund's holdings are rated poorly by rating agencies.

Not too long ago, the annual reports from several of the nation's largest bond funds began to land on my desk. As I looked through these reports, I became increasingly concerned. Bond funds are typically sold as a safe alternative to equity funds; this is one reason why financial planners recommend that investors increase their allocation to bond funds as they age. However, the investments contained in many of these bond funds are anything but safe. In this series of articles, we will examine the contents of several of the world's largest bond funds and show that many are much riskier than most believe. We will begin by looking at the Franklin Templeton Double Tax-Free Income Fund (MUTF:FPRTX).

The Franklin Templeton Double Tax-Free Income Fund has the stated goal of providing a high level of current income that is exempt from both state and federal income taxes. It does this by investing in municipal securities issued by U.S. territories, almost exclusively the territories of Puerto Rico, Guam, and the U.S. Virgin Islands. In general, many investors consider municipal bonds to be safer than corporate bonds largely due to the ability of the state to tax its citizenry but this is not always the case.

Over the past few years, the territory of Puerto Rico has been in the financial news many times due to problems that it has been having with its municipal debt. On May 7, 2015, hedge fund database and information service HedgeCo.net reported that many hedge funds have purchased Puerto Rican government debt and now those funds are actively working with the island's government to avoid a default. The Puerto Rican government has outright stated that unless some sort of funding deal is reached then the government will have to shut down or default on June 30. This default risk is something that the market appreciates, as Puerto Rican government debt is now yielding 10.5%. This is higher than the yield of Greek government debt. Thus, the implication here is that the market believes that Puerto Rico now has a higher probability of defaulting than the nation of Greece does (although Greek government debt is being manipulated by the European Central Bank). Approximately 59.55% of the assets of the Franklin Templeton Double Tax-Free Income Fund consists of Puerto Rican municipal debt, thus a default would have a very detrimental effect on the fund.

Not all of the fund's Puerto Rican municipal holdings consist of tax-backed government debt, however. Some of the fund's holdings are debt issued by the government-owned electric utility, the Puerto Rico Electric Power Authority. Unfortunately, the utility company is also in financial trouble. Of the island's total outstanding municipal debt of $70 billion, $9 billion is owned by the power company, which it cannot afford to pay. A recent article on NPR outlines some of the reasons why. According to the article, Puerto Rico has some of the highest electricity rates in the United States, due largely to tremendous overcapacity that was built out when the island sought to become heavily industrialized decades ago (that still needs to be paid for today). In addition, approximately one-third of the company's customers receive subsidized rates that allow them to pay very little or nothing. City governments and hotels are officially exempt from paying, while many schools and the island's train system simply don't pay for the electricity that they consume. The utility is then forced to transfer the costs of the energy consumed by these users onto everybody else. However, the utility is simply not collecting enough money to cover all of its expenses from those that do pay. As a result of this, the power company is expected to default on its debt in July.

Unfortunately, Franklin Templeton does not disclose exactly what percentage of its fund's portfolio consists of municipal bonds issued by this particular power utility. However, since 59.55% of the fund consists of Puerto Rican municipal bonds and approximately 14.94% of the fund consists of municipal bonds issued by utilities, we can assume that it is a significant percentage. Thus, should the Puerto Rico Electric Power Authority default on its debt, the impact on the fund will likely be significant.

Evidence that this fund is composed heavily of risky assets can be found by looking at the credit quality ratings of the bonds in the fund's portfolio. From the most recent annual report:

Bond Rating

% of Total Long-Term Investments

AAA

6.28%

AA

8.21%

A

19.07%

BBB

27.96%

Below Investment Grade

38.04%

Not Rated

0.44%

Source: Mutual Fund Annual Report

As this chart shows, the vast majority of the fund's assets consist of municipal bonds that are rated BBB or below investment quality. This indicates a high degree of default risk present in the fund's portfolio. This also represents a much higher risk than most investors would assume would be present in a bond-focused mutual fund. Investors in this particular fund are therefore advised to be cautious regarding it.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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