The Muni Brief: Territories and Tax Exemption

Why Puerto Rico Can Issue Tax-Exempt Bonds?

As a legally authorized “Territory” of the U.S., Puerto Rico has long been recognized as an important issuer of tax-exempt bonds. The answer lies in the U.S. Constitution, Article IV, Section 3, Clause 2, which allows Congress to create territorial governments, with taxing authority and borrowing authority.

Puerto Rico has been a U.S. territory since the end of the Spanish-American War in 1898. Its constitution wasn’t formally approved by Congress until 1952, but the borrowing authority that came with territorial status has made it one of the most unique, if not important issuers in the municipal bond market over the past 50 years.

The Triple Tax Exemption

The Internal Revenue Code treats territorial obligations similarly to state obligations. But, for Puerto Rico and other territories, that has meant a unique tax treatment for bondholders.

Interest paid on many Puerto Rico bonds is:

• Exempt from federal income tax
• Exempt from state income tax across all 50 states
• Exempt from local taxes

That’s what the market calls the “triple tax exemption,” and it’s the main reason Puerto Rico debt became so deeply embedded in mainland muni portfolios and mutual funds over the years.

Four other U.S. territories share the same triple exemption:

• Guam
• U.S. Virgin Islands
• Northern Mariana Islands
• American Samoa

How Big Is the Territory Muni Market?

Current debt outstanding from Puerto Rico is approximately $37 billion. Add roughly $5 billion from the other four territories and you’re looking at a combined footprint that, while a small slice of the overall muni market, is significant enough to influence index construction and show up in broadly diversified muni funds. Territory bonds in the VanEck muni ETF suite are held primarily in SHYD and HYD, the two high yield muni funds. Commonwealth General Obligation debt carries a BB rating, which keeps it in high yield territory while a small number of territory bonds do qualify as investment grade. But the bulk of territorial exposure sits in the high yield sleeve.

What Investors Should Keep in Mind

Puerto Rico today, as an issuer of municipal bonds, is a different story than it was at peak crisis. It's more accurately viewed as a post-restructuring territorial credit with materially reduced bonded debt. New Congressional initiatives are being unveiled to stimulate investment and incentivize certain industries to return to the island, including the Supply Chain Security and Growth Act and the MMEDS Act (H.R. 3042), which targets pharmaceutical and medical device manufacturing, sectors with deep historical roots in Puerto Rico. That renewed investment focus, combined with the triple exemption that has always defined territory bonds, gives muni investors reason to believe the best of Puerto Rico's story may still be ahead.