The losses that investors in Puerto Rico bonds and UBS Puerto Rico bond funds have suffered continue to mount, and the downgrade to high risk, or “junk bond” status is only going to make things worse. In 2013 alone, investors in Puerto Rican bonds saw losses of over 20%. However, those losses do not include the leverage that many investors were ultimately exposed to. Many investors were sold proprietary investments funds created by UBS. Those funds borrowed additional funds to be able to purchase even larger amounts of Puerto Rican bonds. This strategy increases the potential gains an investor can make, but also increases the potential losses. Investors in funds that were 50% leveraged, which many UBS funds were, saw losses closer to 40%.
This permitted these UBS funds to see losses of over $1.6 billion. Moreover, these losses do not take into account the losses of investors who were convinced to buy Puerto Rico bonds outside of these funds, or investors who lost additional money through extra leverage sold by their brokers.
Many investors were convinced to borrow more money, either through a margin account, a bank loan, or through a second mortgage, to make even larger investments, exponentially increasing their risk. These layers of borrowed money made it possible for some investors to see their entire accounts get wiped out.
Yesterday, the market for these bonds took yet another blow. Standard & Poor’s, one of the three main ratings agencies for securities, downgraded the vast majority of Puerto Rico bonds to junk bond status. This downgrade will force a number of other mutual funds to sell off their positions in Puerto Rico bonds. Currently, around 70% of U.S. municipal bond funds hold some amount of Puerto Rico bonds. Many of these funds are restricted by their operating documents to only hold “investment grade” bonds, which Puerto Rico bonds no longer qualify as. These funds will be forced to sell at huge discounts to get out of the Puerto Rico bonds, resulting in large price drops for all bond holders.
Additionally, this downgrade could prevent Puerto Rico from borrowing additional funds, despite previously stated plans to do so. Puerto Rico is planning on borrowing an additional $1-2 billion within the next few weeks. However, this downgrade will likely greatly increase the interest rate Puerto Rico agrees to pay in order to convince investors to accept the risks of the bonds. This could have devastating effects on a government which has relied so heavily on borrowed money for the last decade to stay afloat, as well as the investors who rely on that government to pay them back.
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