Puerto Rico Bonds “Scoop And Toss”: When Increasing Yield Is Not A Good Thing

Most investors clamor for investments that generate a high yield, particularly when they have been pitched as safe and secure municipal bonds.

Many investors at UBS and other firms were delighted to hear their financial advisors tell them that the Puerto Rican bonds and closed-end bond funds that they recommended had a higher yield than last year.

But what probably sounded to investors like a sweet song of muni bond high-yields has turned into a cacophony.

According to a recent Wall Street Journal article, Puerto Rico engaged in a municipal bond maneuver called “scoop and toss.” (And no, New Yorkers, this isn’t the kind of scoop-and-toss you do with your dogs during their morning walks around Manhattan.)

This bond “scoop and toss” involves selling new long term debt to raise funds to pay off maturing bonds, effectively extending the timetable for retiring municipal borrowings. Such refinancing, according to the Journal, aims to reduce interest rates but typically keeps the same maturity schedule.

That concept – lowering interest on debt while keeping the same timetable to pay it off – sounds like sound money management. “The practice, which has been around for decades, helps cities, states and other local entities to stay current on their obligations as they try to claw out of the deepest economic downturn since the Great Depression,” according to the Journal’s Mike Cherney.

Higher yielding municipal bonds must sound terrific to investors, particularly at a time of record low interest rates on Treasuries. As Cherney noted about “buy and scoop”: “The debt sales often offer above-market interest rates that appeal to many bond buyers at a time of slow economic growth, easy Federal Reserve policy and low rates on relatively safe investments such as U.S. Treasury securities and bank accounts.”

But “scoop and toss” carries a lot of risk, particularly as it extends the timetable for repaying off the municipal debt. While it’s not a direct comparison, but imagine if a homeowner perpetually refinanced their property, but at higher interest rates. They would never wind up owning their home and they would see their equity continue to erode, all the while paying the bank more and more.

Here’s the danger, according to the Journal: “Some observers warn that scoop-and-toss refinancing add to interest costs while allowing civic managers to overlook structural economic difficulties. Investors purchasing the debt take on the risk that the securities will lose value, as they did in Detroit’s $18 billion Chapter 9 bankruptcy case.”

“It’s never a good sign to see this,” according to one portfolio manager in the Journal’s report.

“In 2011, Puerto Rico sold $356 million of bonds that began maturing in 2024,” according to the Journal. “Some of the proceeds were used to pay off a bond from 1989 that was maturing in 2011 – in effect turning a 22-year bond into a 35-year one.”

It is unlikely that many brokers pedaling Puerto Rico bonds or bond funds actually gave such a warning to their clients regarding this refinancing practice. Rather, they likely hyped the wares that they were peddling as safe and secure.

In fact, the yield on Puerto Rico General Obligations Bonds has risen from 3% in 2012 to over 6% in 2013. Rather than rejoicing about the yield, investors should have been warned of the increasing risk of a possible default or significant decline in the value of the bonds. Rising bond yields mean the value of the bonds is going in the opposite direction – in the case of Puerto Rico bonds, straight down.

There are no short-term solutions for the problems of Puerto Rico or its debt holders, many of whom are mom and pop investors. Puerto Rico’s debt load, which has doubled over ten years to reach $65-70 billion, now amounts to 93% of the island commonwealth’s gross domestic product, more than troubled Spain, though still far short of Greece’s 176%, according to a report this week from Newsmax.

Too much yield on Puerto Rico and other muni bonds, turns out, is like drinking too much punch at the office holiday party. Someone spiked the punchbowl with the cheap stuff, and you wind up sick in the morning.

Zamansky LLC are securities and investment fraud attorneys representing investors in federal and state litigation against financial institutions. For more information about Zamansky LLC, please visit http://www.ubspuertoricofunds.com/.

About Jacob H. Zamansky 57 Articles

Jacob (”Jake”) H. Zamansky is one of the country’s foremost authorities on securities arbitration law, the legal recourse for investors claiming broker wrongdoing, or for brokers claiming wrongful termination or other misconduct by their employer. Zamansky & Associates, the New York-based law firm he founded, represents both individuals and institutions in complex securities, hedge fund, and employment arbitrations.

Mr. Zamansky was at the forefront of recent efforts to “clean up” Wall Street. In 2001, he successfully sued former Merrill Lynch analyst Henry Blodget on behalf of a New York pediatrician misled by Blodget’s stock research. The case’s successful resolution was the catalyst for New York Attorney General Elliot Spitzer to investigate the conflicts of interest on Wall Street and resulted in the well-reported $1.4 billion Global Settlement, which included many of the biggest names on Wall Street.

More recently, Mr. Zamansky is one of the leading litigators and opinion leaders of the subprime mortgage crisis and the related hedge fund collapses, representing both investors and mortgage borrowers who were defrauded by Wall Street firms and mortgage lenders. Among Mr. Zamansky’s early actions is filing the first arbitration case on behalf of institutional and high net worth investors against Bear Stearns Asset Management with regard to the two hedge funds which collapsed as a result of exposure to subprime mortgage backed securities. He also has filed claims on behalf of individual investors victimized by brokers that steered their portfolios into unsuitable subprime stocks and mortgage borrowers who were fraudulently coerced into inappropriate mortgage and investment transactions.

Earlier in his career, Mr. Zamansky worked for more than 30 years as a litigator, including positions at Skadden Arps, Slate, Meagher and Flom LLP. His tenure also included serving as a federal prosecutor with the Federal Trade Commission.

A native of Philadelphia, Mr. Zamansky has been a frequent expert commentator on CNBC, CNN, and FOX News and has published opinion pieces in The Wall Street Journal, Financial Times and USA Today. He is regularly quoted and his cases have been chronicled in major financial and news publications including The New York Times, USA Today, The Washington Post, BusinessWeek, Fortune and Forbes. He is a frequent lecturer for industry and legal groups around the country. He also writes a blog that can be viewed here.

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