Investment Lessons Courtesy of Puerto Rico
For several years now the financial press has been reporting about the fiscal and economic woes hitting the Commonwealth of Puerto Rico. As in many stories of financial distress, debt plays a leading role. Depending on who is doing the accounting, the Commonwealth has somewhere between $53 billion and $70 billion in outstanding bonds. Puerto Rico has had a national market for its debt because the interest is tax exempt in all fifty-states. In addition, Puerto Rico enjoys the usual federal tax exemption given to all municipal debt. As doubts have risen about Puerto Rico’s ability to service this mountain of debt, bond prices have tumbled (see the chart below), and we are getting yet another lesson in the dangers of chasing yield and using leverage.
Lesson 1: How to turn a 5.5% yield into a 14% return.
UBS, a leading bank on the island, lured wealthy investors into a private fund made up of Puerto Rican debt. The fund was made up of about 50% equity and 50% debt. The idea behind the leverage was to magnify the returns on the debt. However, UBS brokers went even further in applying leverage by encouraging their clients to borrow money instead of only putting their own equity into the fund. Since the fund wasn’t registered, we don’t know the particulars, but I’ve set up an example (see table 1) to show how what the brokers might have been promising their clients.
With Puerto Rican debt sporting an interest rate of about 5.5% and the cost of borrowing (broker loan rate) at 2%, there’s a nice spread between what investors could earn and the cost of borrowing. We’ll even throw in a 1% management fee, so UBS doesn’t go away empty handed. Suppose investors put a $1,000 into the fund, where $500 is their cash and $500 is borrowed. Then suppose the manager takes that $1,000 and borrows another $1,000, so that the fund can buy $2,000 worth of bonds for the fund. At the investor level, a $500 investment controls $2,000 worth of bonds, which should generate $110 of income. Of course, the interest on the debt has to be paid, which will cost $30, and the manager has to get his fee of $10. However, the investor ought to be ecstatic because he netted $70 on a $500 investment or 14% (that’s a 20% plus return before taxes).
Lesson 2: How a 20% price drop can turn a $500 investment into a $100 investment
The market for Puerto Rican bonds isn’t terribly liquid. Most bonds are purchased as new issues, and the secondary trading market is thin. Not surprisingly as the Commonwealth’s problems have become more apparent, prices have been falling. As the chart above shows, prices have fallen about 20%. As a result the $2,000 bond fund would now own $1,600 worth of bonds. However, the fund still owes $1,000, and the investor owes $500 that he personally borrowed. Deduct $1,500 in debt from $1,600, and there’s only $100 left over of the $500 in cash originally invested. In short, applying leverage to risky credits has caused the investors to lose most of their money.
Lesson 3: The muni problem in Puerto Rico may apply to you
North Carolina is about 1,400 miles from Puerto Rico, so surely their distress isn’t a problem to investors in our state or anywhere else outside the Commonwealth. I am sure there a few credit-related hedge funds that dabbled in leveraged Puerto Rican credits, so there’s probably some pain being inflicted on wealthy individuals or institutions.
However, it is far more likely that Puerto Rican credits are in your North Carolina or national tax-exempt mutual fund. Since territorial debt isn’t subject to state income tax, money managers have added Puerto Rican muni debt to their portfolios in order to spice up the yield a little bit. Because North Carolina enjoys a strong credit rating, its municipal debt has substantially lower yields than comparable paper issued by Puerto Rico. Thus, a money manager can make his product seem a bit more attractive by adding Puerto Rican debt to the portfolio and juicing up the yield.
For example, the Franklin NC Tax-Free Income (FXNCX) had 13% of its portfolio in commonwealth paper as of its last annual report. While this investment boosted the yield, it has also helped to drive the fund’s price down by 7.6% this year. Obviously, rising interest rates and credit problems in Detroit and other municipalities have helped to drive down the prices of municipal bond mutual funds. If you own a municipal bond fund, you might want to take a quick peak at its holdings. Some mutual funds, like Franklin, make it easy because all the territorial credits are listed together. Most mutual funds, however, will require you to carefully look through the holdings list in the annual or semi-annual report because the Puerto Rican holdings are mixed in with all the other credits.
Conclusion: All of us would like to earn more income on our bond investments. For the past several years, yields on quality instruments have been anemic. However, Puerto Rican municipal paper offers an important reminder that when a bond sports a significantly higher interest rate than a comparable investment, the “extra” interest comes with additional risk.