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Puerto Rico Municipal Bond Crisis - The Effects of Double Leverage

Posted by Jack Duval

Nov 25, 2013 8:18:00 AM

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.[1]

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.[2]

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.)[3]

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.[4]

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.


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[1]              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

[2]              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.

[3]              Michael T. Curley, Margin Trading from A to Z; (John Wiley & Sons, Inc., Hoboken, 2008); P.70.

[4]              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.








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Topics: Puerto Rico Municipal Bond Crisis, Closed-end municipal bond funds, Margin leverage

Puerto Rico Municipal Bond Crisis - Understanding Closed-end Bond Funds

Posted by Jack Duval

Nov 22, 2013 8:44:00 AM

Much of the litigation about the Puerto Rico municipal bond crisis involves leveraged closed-end bond funds, in particular those sold by UBS.  As part of our continuting expert analysis of this crisis and subsequent litigation, we have prepared a short primer to help litigants understand closed-end municipal bond funds.

Understanding Closed-end Municipal Bond Funds

Closed-end funds are initially offered through an underwriting and the number of shares remains constant. These shares will then typically be traded on an exchange. Unlike their open-end cousins, closed-end funds may trade at, above, or below net asset value. Typically, municipal bond funds will trade near or below their new asset value, although they do trade above their net asset value on occasion.

Traditionally, closed-end municipal bond funds have distributed the net income generated by the underlying bonds in the portfolio. More recently, some funds have been using a “managed distribution” policy. Under a managed distribution policy, the closed-end fund sets a distribution rate and if the underlying municipal bonds do not generate enough income, principal is used to bring the total distribution up to the predetermined level.

Managed Distributions

Over time, a managed distribution policy can erode the principal amount invested in the fund. This can be a significant risk for the investor if they rely on their investments for living expenses, as in the case of retirees. For such an investor, a managed distribution policy can facilitate the unknowing consumption of their own principal. This could leave them with a depleted asset base from which to generate income for their expenses.

Most investors are unaware of managed distributions and assume the distributions they receive from closed-end bond funds are interest payments from the underlying funds. FINRA published an Investor Alert on October 28, 2013 to address these issues and explain the differences between an investment yield and a distribution. [1] In this Investor Alert, FINRA explains:[2]

"When looking at closed-end funds and traditional mutual funds, keep in mind that distribution rates and yields are different measures. A mutual fund's yield shows its interest and dividend income expressed as a percentage of the fund's current share price. With a closed-end fund, the distribution rate might also include a return of principal…
Closed-end funds that return capital can carry a higher level of risk because the fund is eroding the asset base it has to generate income to pay distributions. Some closed-end funds set a specific distribution rate to pay regardless of the income generated by the fund. In that case, it is more likely that a fund may return capital to investors along the way. Before you invest in a fund, find out if the closed-end fund follows this approach—also known as a managed distribution policy."

Furthermore, investors might not want to invest in a new issue closed-end bond fund (where a 4.5 percent commission is typically charged on the total amount invested) if the fund is going to return their own principal back to them.

Accelerant will have a white paper from fixed income expert Gerry Guild, analyst Jay Dulski, and CEO Jack Duval coming soon.


[1]                 See FINRA Investment Alert “Closed-End Fund Distributions: Where is the Money Coming From?”, 10/28/13. Available at; Accessed November 22, 2013.

[2]                 Id.



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Topics: Puerto Rico Municipal Bond Crisis, Closed-end municipal bond funds, Managed distributions

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