Why Puerto Rico Investors Pursuit of Tax Free Income Led to Financial Ruin

UBS Financial Services of Puerto Rico and its financial advisors have placed investors in great peril chasing tax-free income through investments in UBS Puerto Rico Family of Funds without regard to the risks and consequences of their investment advice. This lesson should have been learned by financial advisors during the mortgage meltdown. Before the credit crisis investors flocked to Mortgage Backed Securities (MBS) because of the yield and great credit ratings. How could you lose chasing the higher yields paid by MBS investments? In the pursuit of greater after-tax income, Puerto Rico investors were duped by their financial advisors with a false choice rationale through a comparison between “tax free” vs. “taxable” income. In this instance, tax-free income for Puerto Rico residents meant risky investments in the tiny island economy to achieve the tax free income. How could someone ignore such a risk? Usually, greater after-tax income is a “good thing”, but not at the expense of concentrating your investment portfolio in Puerto Rico issued bonds, this pursuit should have been a “red” flag. This lesson should have been learned from the credit crisis in 2008-2009, but again the risk was completely ignored.

Chasing Yield Is Not A Good Choice

So what made the UBS Puerto Rico Family of Funds such a bad bond fund investment? Any one factor might not have been a cause of concern, but there were enough red flags that UBS Financial Services of Puerto Rico, through its sales force and other brokerage firms with selling agreements, should have known that chasing after-tax yield should not have been the advice given to Puerto Rico investors. In fact, the primary reason given to Puerto Rico investors for the investment recommendations was the high tax rates they faced and that tax-free Puerto Rico bonds was the only way to avoid taxation. For Puerto Rico investors, the proverbial tax tail was wagging the investment dog. The universal bond investor axiom was ignored, “that there is no free lunch”. In other words, there is no “extra” source of return that is not accompanied by greater risk. Sometimes it’s as obvious as credit risk borne by a tiny island Commonwealth reliant on tourism and few industries as a revenue base; sometimes it’s a lack of liquidity. But it’s always exists, unless hidden and obscured by zealous sales pitches by trusted financial advisors. Naturally, Puerto Rico bond funds that yield the most “after-tax” income will attract a lot of Puerto Rico investor attention, unless financial advisors can be trusted to temper this pursuit with suitable investment advice. New lesson here, bond funds that get into the biggest trouble are most often those with the greatest “after-tax” yields.

Geographic Concentration and Lack of Liquidity

What is securities concentration? It exists in a municipal bond fund with exposure to a limited number of issuers, single sectors and single state. UBS Puerto Rico Family of Fund investments were exposed to all of these risk factors. Concerning these UBS proprietary closed-end bond funds, too much of a “good thing” was no different than having “all of your eggs” in one basket. UBS Financial Services of Puerto Rico Puerto lauded the Commonwealth’s good credit ratings, as justification for geographic concentration when in the past such reasoning led many subprime-mortgage investors to financial destruction. Lack of liquidity for the non-traded, illiquid UBS proprietary closed-end bond funds requires, if not demand, limiting the exposure to an investment that cannot be sold. Most brokerage firms place limits on the amount a client can invest in illiquid investments such as non-traded Real Estate Investment Trusts to 10-15% of an investors net worth. Contrary to this standard, UBS Financial Services of Puerto Rico’s financial advisors recommended investing the vast majority of their client’s assets in tax free Puerto Rico bonds through UBS’ proprietary non-traded closed end bond funds.

When Does Leverage in Bonds Fund Make Sense?

Almost never! In past years the use of leverage in bond funds was diametrically opposed to the notion of safety of principal. Why introduce risk into bond fund investments that are supposed to be deemed suitable for conservative investor’s need for current income? Leverage in any investment portfolio, even bond funds, are designed to magnify gains, but also losses, thus making your investment more volatile. Being able to amplify investment returns is not always bad, but the more leverage you use, the more risk you take. Some money managers justify using leverage to skew investment returns during periods of rising markets, but the UBS Puerto Rico Family of Funds employed 50% leverage as a permanent measure which almost certainly assured wild swings in value. While the Prospectus disclosures only illustrated the effects of leverage should the underlying assets decline by only 10%. No wonder everyone including UBS Financial Services of Puerto Rico was in shock when roughly $10 billion in their proprietary closed-end bond funds lost a majority of its value.

Higher Costs Assume More Risks

Compared to most closed-end bond funds, UBS Puerto Rico Family of Funds had operating expenses and management fees that were so high that some argue the use of leverage was necessary to generate the higher yields needed to offset closed-end fund costs. Higher fund costs, in turn,  require exposure to greater risks which made this investment strategy unsuitable for most conservative investors interested in current income.  The domino effect becomes clear when costs are taken into consideration.  Managers who have to cope with higher expense ratios have added pressure to assume more risk.

What Can Be Done to Avoid Investment Mistakes

There are a few pitfalls investors should consider to avoid investment mistakes. First, avoid concentrated investments in any type single type of security. Minimize exposure to any single issuer, sector, geographical region, or type of financial product. Second, avoid leverage justified by any promise of higher returns. The more leverage you use, the more risk you take. Beware of the use of derivatives in lieu of borrowing which magnify gains and losses alike. Third, avoid higher costs whenever possible unless there is an indispensible reason for the strategy to incur the additional fees and costs. The costs of leverage, derivatives and transaction costs all increase the breakeven point for an investment strategy which requires greater investment risk. Fourth, avoid investment strategies that are unconventional to gain incremental investment returns by accepting more risk.

Klayman & Toskes, P.A. is dedicated to the recovery of Puerto Rico investor losses in UBS Puerto Rico Family of Funds that are the result of violations of FINRA sales practice rule and regulations.

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