BOSTON Aug 5 (Reuters) — Money market funds run by Fidelity and American Beacon are relying on an unlikely source to juice up their returns: beat-up bonds issued by cash-strapped Puerto Rico.

The funds have accepted the U.S. territory’s debt as collateral on their short-term loans to Wall Street banks, and in exchange for that added risk are receiving a higher interest rate, according to public filings.

As a result, American Beacon’s $767 million fund has one of the best one-year returns in the industry, while Fidelity this year used at least one loan backed by Puerto Rico bonds to generate a yield about 20 basis points higher than U.S. Treasuries or bank certificates of deposit.

The strategy comes as the money market fund industry seeks to retain investors spooked by new U.S. regulations, and could stir up worries about market risk that emerged after the 2008 financial meltdown, according to analysts.

So far, repurchase agreements backed by some of the riskiest collateral make up just 3 percent of the $2.4 trillion in taxable money market fund assets, according to research firm Crane Data LLC. But that could grow if the improved returns among those using riskier collateral prove to be a draw for investors.

The American Beacon Money Market Select Fund, for example, has nearly a third of its repurchase agreements backed by riskier collateral. As payoff, the fund’s one-year total return of 0.08 percent through the end of July is better than 91 percent of peers, according to data from Lipper Inc, a unit of Thomson Reuters. The fund’s five-year annualized total return of 0.21 percent, as of Dec. 31, also beat nearly 90 percent of peers.

In recent months, the American Beacon fund has used a $39 million repurchase agreement with RBC Capital Markets LLC to generate a yield of 18 basis points. In April, the collateral in the deal contained about $6 million worth of Puerto Rico bonds, including ones issued by the island’s electric authority.

Standard & Poor’s said last month the Puerto Rico Electric Power Authority is likely to default on its credit lines and file for protection under a new restructuring law. PREPA bonds were not listed as collateral in the fund’s end-of-May report, though.

The fund is a survivor of the financial crisis, but heavy redemptions left it with just $708 million in assets at the end of 2008, down from $11 billion at the beginning of that tumultuous year, according to Lipper.

American Beacon declined to comment for this story.

‘BREAK THE BUCK’

Money market fund sponsors downplay the collateral risk associated with repurchase agreements, saying their ultimate backstop is the bank on the other side of each transaction.

Prime money market mutual funds only enter into repurchase agreements with counterparties that represent ‘minimal credit risk,’ Fidelity Investments, the largest U.S. money market fund sponsor, said in a statement.

The $13 billion Fidelity Retirement Money Market Fund recently reported a $126 million repurchase agreement with Merrill Lynch, which had a yield of 0.38 percent and featured Puerto Rico bonds as most of the deal’s collateral, according to fund disclosures.

About 10 percent of the fund’s repurchase agreements are backed by collateral considered more risky, according to Fidelity disclosures. Fidelity’s fund returned one basis point for investors over the past year, a typical performance in the industry.

The risk around counterparty banks is partly why U.S. regulators have had concerns about repurchase agreement collateral since the financial crisis. The possibility of collateral fire sales still poses significant risks for the U.S. financial system, according to the Financial Stability Oversight Council’s 2014 annual report released in May.

A redemption run on the Reserve Primary Fund in 2008 has been a rallying cry for reform after its exposure to Lehman Brothers debt prompted panicked investors to withdraw their money in droves. That run led the fund to break the buck, a rare event in the money market fund industry that refers to a fund’s net asset value falling below $1 per share.

New rules passed last month by the U.S. Securities and Exchange Commission are designed to limit redemption runs, but they could make life harder for money market funds. A floating net asset value for some funds could make them less appealing to investors who prefer the stable $1 share price.

That could push money market fund assets into customized separately-managed accounts, for example, which contend with less regulatory oversight, said Josh Galper, managing principal at Finadium LLC.

That competition might encourage more money market funds to enter into more repurchase agreements with riskier collateral. A repurchase agreement with municipal bonds as collateral can generate a yield premium that is 30 basis points to 40 basis points better than a deal with U.S. Treasuries, Galper said.

This can make muni repo an attractive short-term cash investment especially when a U.S. treasury repo is running at 8 or 9 basis points, he added. (Reporting by Tim McLaughlin; Editing by Richard Valdmanis and Paul Simao)