Monday, October 7, 2013

Trouble in Paradise: UBS Puerto Rico Bond Fund Investors Hit Hard

By Tim Dulaney, PhD, FRM and Carmen Taveras, PhD Versión en Español

Despite a 2012 settlement agreement with the SEC, UBS Puerto Rico continues to face new allegations regarding its sales practices of tax-advantaged closed-end funds. While UBS Puerto Rico did not admit wrongdoing when it settled with the SEC, an SEC statement on the matter said “UBS Puerto Rico denied its closed-end fund customers […] accurate price and liquidity information, and a trading desk that did not advantage UBS’s trades over those of its customers.” At the time of the SEC settlement, the firm placed $26.6 million dollars into a fund for harmed investors. According to new allegations, UBS Puerto Rico is said to have encouraged investors to use lines of credit – rather than margin loans – to purchase shares of its closed-end funds.

We have reviewed the UBS Puerto Rico closed-end funds involved in the allegations. The 14 closed-end funds managed solely by UBS asset managers in Puerto Rico (PDF) had total assets of $3.78 billion as of second quarter 2013.[1] Like other closed-end funds, the funds’ shares were sold at an Initial Public Offering (IPO) and are not redeemable until the funds liquidate. Shares of the UBS Puerto Rico funds are sold exclusively to residents of Puerto Rico, received preferential tax-treatment, and are not registered as investment companies with the SEC.

The funds invested mostly in fixed income securities from Puerto Rican issuers, including a large allocation to Puerto Rican municipal bonds. The funds were allowed to leverage their purchases of assets. As an example, the Puerto Rico Fixed Income Fund could issue debt securities worth up to 50% of its total assets. By allowing purchases of the funds’ shares using lines of credit, UBS facilitated further leverage in their customers’ accounts.

Amid a prolonged contraction of the Puerto Rican economy that has impacted the island’s ability to collect taxes as well as broader concerns about the US municipal bond market as a whole, the NAVs of some of the UBS Puerto Rico Funds have fallen precipitously this calendar year. For example, the NAV per share for the Puerto Rico AAA Portfolio Target Maturity Fund has declined by nearly 10% in the first six months of the year.

According to the New York Times, investors that borrowed on margin to purchase shares in the funds have “been forced to liquidate hundreds of millions of dollars in holdings in these funds” at the depressed prices to meet margin calls. In addition, a recent FINRA complaint against UBS Puerto Rico cited by Bloomberg accuses the firm of violating loan procedures required by the Federal Deposit Insurance Corp. by opening lines of credit to UBS clients and investing the loan proceeds in shares of the funds.

The dangers of the doubly-leveraged strategy have materialized. The funds’ assets, which include bonds issued by the commonwealth government’s notoriously underfunded retirement system, have dropped in value. For example, one such holding of the Tax-Free Puerto Rico Fund (CUSIP: 29216MBP4) was trading in the around $90 for the first six months of 2013 but has dropped to around $50 in the last few weeks.

Nevertheless, the funds must still pay their debt obligations, and so must investors that purchased shares using lines of credit. Investors have suffered significant capital losses and continue to be exposed to extraordinary risks of leverage.
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[1] According to the “UBS Asset Managers of Puerto Rico Funds Quarterly Review Second Quarter 2013”, accessed here on October 4, 2013.

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