Will Puerto Rico Municipal Bonds Default?

This question is on the minds of many investors.  Many clients and potential clients have contacted our firm concerned about the effect of a default on their UBS Puerto Rico municipal bond funds that are heavily invested in the island’s debt

The UBS Puerto Rico bond funds, including the Puerto Rico Fixed Income Fund and the Puerto Rico Investors Tax-Free Fund series, invested up to 140% in Puerto Rico debt through the employment of leverage.  The extreme use of leverage has exacerbated recent declines.  As losses continue to increase clients tell us very similar stories about how their brokers recommended that they invest as much as 100% of their portfolios in the UBS Puerto Rico closed-end funds.

Now our clients worry about a potential Puerto Rico default on its municipal debt.  Puerto Rico’s public debt of $53 billion is nearly $15,000 per person.  When you add on the severely under-funded pension and healthcare obligations, the amount of debt approaches $160 billion, or $46,000 per person.

How did we end up here?  The same familiar Wall Street story.  First, Puerto Rican bonds are free from all State, Federal and local taxes, providing a very attractive yield.  Second, the promise of safe high-yielding investments that some are comparing to the promises made to investors who purchased high yielding subprime mortgage CDOs in 2007.  Finally, politicians and policy makers who have no interest in stopping the underwriting, issuance, and debt selling machine.

But will Puerto Rico default on its debt?  One problem is that Puerto Rico’s financial health is difficult to diagnose.  A Forbes contributor recently wrote, “[t]here’s less transparency on Puerto Rico’s true financial health than there was coming out of Lehman Brothers in 2008.”  For example, audited financial statements for June 2012, only became available to investors in September 2013.  Unsurprisingly, the disclosure of the financials corresponded with a significant drop in the value of Puerto Rico municipal debt.

Puerto Rico may not want to release its financial data because the financial reality is nowhere near the government’s projections.  In 2013, Puerto Rico projected a $300 million deficit.  When the numbers were released the government had a $2.2 billion deficit, not a small miss.  Investors need transparency and realistic tax and deficit projections from bond issuers in order to be satisfied that the debt is under control.  Instead, it is becoming increasingly difficult for investors to trust that Puerto Rico will get its finances in order or provide accurate projections.

While it is impossible to predict when or how Puerto Rico’s debt crisis will come to an end, some experts predict that some modification to the island’s debt will have to occur.  First, Puerto Rico has been shut out of traditional debt markets.  Thus, continuing upon the current path will lead to ever higher and more difficult to sustain interest rates.  Second, the present math simply does not work.  A 9% interest rate on Puerto Rico’s $70 billion of debt is $6 billion a year of interest for a country with only a $10 billion annual budget.  It is likely that bond investors at some point will be asked to make a sacrifice in order to place Puerto Rico on a sustainable path to solvency.

The attorneys at Gana LLP are experienced in handling claims involving the UBS bond funds.  Our attorneys can help you detect and uncover suspicious activity in your accounts.  Our consultations are free of charge and the firm is only compensated if you recover.