This blog post continues our expert analysis of the Puerto Rico municipal bond fund crisis. The recent decline in Puerto Rico municipal bond prices has triggered a wave of litigation, particularly where clients of UBS owned propritary closed-end municipal bond funds and used account margin to purchase additional shares.
Many of the UBS Puerto Rico closed-end municipal bond funds used internal fund leverage. If account margin was utilized as well, then the initial investments were double leveraged. Our experts have prepared a brief explanation of how an initial investment can be leveraged 400 percent under such a scenario.
Internal Closed-end Fund Leverage
Many closed-end municipal bond funds permit the use of leverage. Indeed, it is common for closed-end funds to have leverage ratios of 35 to 50 percent (calculated on the total portfolio after the leverage has been used to purchase additional securities) so the holdings of municipal obligations could be 50 to 100 percent higher than the amount of capital initially raised. The amount of leverage allowed in a closed-end bond fund is specified in the prospectus and how much is actually utilized is reported at least every six months in the funds Certified Shareholder Report filing.
The leverage inherent to a closed-end fund is not obvious to an investor from looking at their financial statements.
Margin Account Leverage
Investors may utilize leverage at the account level whereby they borrow against the assets in their account to purchase more securities. This is known as margin. Municipal bonds may be purchased on margin. While stocks are subject to Regulation T margin requirements, municipal bonds are not, they are classified as an exempt security.
The margin requirements for municipal securities are set by the NYSE. Currently, the initial and maintenance requirements are the greater of 15 percent of the market value or seven percent of the principal. Generally, this means the margin requirement for municipal bonds will be 15 percent (unless the market value of the bonds were to fall precipitously.)
A 15 percent margin requirement means that an investor could leverage the cash in their account over six times. As an example, a customer who deposited $100,000 in cash could purchase roughly $660,000 worth of municipal bonds.
1 + 1 = 4
If a customer buys a leveraged closed-end municipal bond fund that utilizes internal leverage and then uses account margin to purchase more of that security, their initial investment could end up leveraged four times. This means that a 25 percent decline in the underlying municipal bonds would wipe out the customer's equity. Further declines would leave the customer owing the broker dealer more than they had initially invested.
We will be publising a white paper about the Puerto Rico Municipal Bond Crisis shortly. This paper will be written by fixed income expert Gerry Guild, analyst Jay Dulski, and CEO Jack Duval.
 Certified Shareholder Reports are available on the SEC EDGAR website and are coded as a Form N-CSR. They are also mailed to shareholders of record. For more information, see http://www.sec.gov/about/forms/formn-csr.pdf.
 Regulation T set margin requirements for equities and equity derivatives, like convertible bonds, at 50 percent in 1974 and it has remained constant through today. The actual rate may vary and is set by the Federal Reserve Board of Governors.
 Michael T. Curley, Margin Trading from A to Z; (John Wiley & Sons, Inc., Hoboken, 2008); P.70.
 In actuality, no one would initiate a position where they were right up against the maintenance margin requirement. If they did, a small move against them would put the account into a margin call, and subject to liquidation by their Broker-Dealer. More likely would be the use of less leverage, giving the investor a cushion against any downside volatility.