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The Government Development Bank for Puerto Rico, the Puerto Rican government agency responsible for its debt deals has hired a well-known debt restructuring firm leading many in the financial industry to speculate that Puerto Rico is preparing to revamp its municipal debt.

According to news reports, Puerto Rico officials refused to say whether the firm was hired as part of an effort to restructure the commonwealth’s debt.  However, the firm has represented many financially challenged countries such as Greece, Iraq, Iceland and Argentina.

Puerto Rico’s Constitution prohibits it from filing for federal bankruptcy protection like Detroit or other United States municipalities have done in the past.  Accordingly, the prospect of restructuring Puerto Rico’s debt has caused uncertainty among Puerto Rico bond investors as to the effect such will have because there is no template or precedence to follow.  As Puerto Rico appears to be seeking to reduce its debt load, Puerto Rico investors worry that a restructuring of the debt could result in additional losses to the large losses already suffered on their bond holdings or the closed-end funds held by many of Puerto Rico residents.

The Standard & Poor’s and Moody’s credit ratings agencies downgraded Puerto Rico’s general obligation bonds to BB+ and Ba2, respectively, which is below the investment grade status given to most U.S. municipal bonds. The downgrade had been prognosticated by many brokerage firm research analysts, including UBS Financial Services (UBS) over the last several weeks. UBS Financial Services’ recent report Municipal Brief: Puerto Rico Credit & Market Update dated January 29, 2104, predicted downgrade and additional problems for Puerto Rico Municipal Bond Investors. The reported sentiments of UBS Wealth Management research analysts Thomas McLoughlin and Kristin Stephens are clear, “The probability of a downgrade of the Commonwealth’s GO and related bond ratings by all three ratings agencies into the non-investment grade category by the end of the fiscal year (30 June 2014) is high. Given the myriad obstacles facing Puerto Rico, we believe that at least one rating agency will take such an action within the next 30 days.” UBS research opinions were also consistent with recent moves by S&P Dow Jones Indices which oversees the methodology used for constructing the S&P National Municipal Bond Indices that are used by investors to track the performance of municipal bonds issued throughout the U.S.

On December 20, 2013, S&P Dow Jones Indices announced the removal of U.S. territories, including Puerto Rico, from the S&P Municipal Bond “investment grade indices.” According to S&P Dow Indices, the removal of Puerto Rico municipal bonds as a component from the U.S. National Municipal Bond Market indices was due to dissimilarities between the “performance and characteristics” between the U.S. territories, including Puerto Rico, and the universe of “investment grade” municipal bonds issued by states and municipalities throughout the country. These changes were originally to be made on a gradual basis through March 2014. On January 8, 2014, S&P Dow Jones Indices hastened the removal of U.S. territories, including Puerto Rico municipal bonds, from S&P National AMT-Free and S&P AMT-Free Municipal Series Indices which was now effective January 2014 month end.

The removal of Puerto Rico municipal bonds from the universe of “investment grade” municipal bonds could potentially result in increased sell orders from municipal bond portfolio managers driving prices lower. Selling pressure from municipal bond portfolios including large mutual funds that hold Puerto Rico municipal bonds could be required because of fund-imposed “investment grade” mandates or money manager negative sentiment about the Puerto Rican economy. UBS Puerto Rico Family of Funds, including UBS Puerto Rico Fixed Income Funds and UBS Puerto Rico Investors Tax Free Funds, that are leveraged 50% against an underlying portfolio of Puerto Rico municipal bonds which may soon face lower prices. The effects of leverage on further price declines could be disastrous for closed-end funds that are illiquid and non-traded.

FINRA, the securities industry watchdog, recently updated an Investor Alert for investors who purchase securities with “borrowed funds.”   According to the alert, investments made with borrowed funds by investors grew substantially in 2013.  Investors are warned that the risk of margin calls is significant and they should better educate themselves about these risks before investing with borrowed funds.  Investors must understand investing with borrowed funds and the risks of a margin call, in the event, securities used as collateral decline in value.  The risks investors should understand about margin calls include:

  • the forced sale of securities;
  • no prior notification required;
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