The Securities Litigation Expert Blog

Puerto Rico Municipal Bond Crisis - Individual Municipal Bonds

Posted by Jack Duval

Nov 27, 2013 6:41:00 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.  However, there has also been litigation by investors who owned Puerto Rico municipal bonds directly.

This blog post focuses on individual Puerto Rico municipal bonds (as opposed to those owned in open or closed-end municipal bond funds).

Background

Municipal bonds are typically issued by states and municipalities and their interest payments are generally exempt from Federal tax.[1]. Municipal bonds are also generally exempt from state and local taxation for taxpayers in the locality; for instance, New York City obligations are exempt from both New York State and New York City taxation for residents of New York City.

The municipal bond market is a key component of our capital markets, particularly for state and local governments that need to raise money for infrastructure, hospitals, schools and other capital intensive projects. Municipal bonds consist mainly of General Obligation and Revenue obligations. General Obligation bonds are backed by the full faith and credit of the issuer and are a first lien on the taxes raised. Revenue obligations are backed by the income generated by the issuing entity, such as tolls from a bridge. Variations including taxable municipals also exist but are a lesser component of the marketplace.

Credit Ratings

Municipal debt is usually rated by one or more of the three major rating agencies with Aaa to Baa3 considered investment grade. [2] Like all debt instruments, the risks of the investments should be determined to ascertain whether the potential rewards justify undertaking those risks. Probably the greatest risk is liquidity, the ability to sell the security prior to maturity.

Bond Insurance

Often municipals will purchase a form of “credit enhancement” by have their debt issues insured. The typical effect of this is to elevate the rating on the bonds being issued to Aaa from the lower rating on its own merits. Municipalities will insure their debt at issuance if the cost of the insurance enables an even greater interest rate savings for the issuer. It is a simple arbitrage calculation.

In the event of a default, the bond insurance is only as good as the reserves of the insurance company, which typically insure hundreds of times their capital. While isolated defaults can strain a bond insurer, widespread defaults can bankrupt them. Therefore a useful axiom is never to buy an insured municipal obligation unless you would buy it on its own investment merits. [3]

 

Get Updates on the Puerto Rico Municipal Bond Crisis

 

Notes

[1]                 Municipal bonds may be subject to the Alternative Minimum Tax.

[2]                 Moody’s ratings. Standard & Poors’ and Fitch are similar, with AAA to BBB- being considered investment grade.

[3]                 Traditional bond risks include: liquidity, credit, spread, maturity, and interest rate.

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.

 

 

 

 

 

 

 

 

 

 

 

Read More

Topics: Puerto Rico Municipal Bond Crisis, Puerto Rico municipal bonds

Subscribe to Email Updates

Recent Posts

Posts by Topic

see all