Insured versus Uninsured Puerto Rico Bond Losses and Yields

By Craig McCann, PhD, CFA, Mike Yan, PhD, CFA, FRM and Susan Song, MA 

We’ve written extensively about the UBS Puerto Rico Closed End Funds. These funds were concentrated in the riskiest subset of Puerto Rico municipal bonds – uninsured bonds with little or no market outside of the proprietary UBS funds. Our prior posts on Puerto Rico can be found by clicking here.

In this post we demonstrate that Puerto Rico bond and bond closed end fund losses can be explained by the extent to which the Puerto Rico bonds held were insured rather than uninsured.

Insured versus Uninsured Puerto Rico Bonds

In Figure 1, we plot price indices for insured and uninsured Puerto Rico bonds. We created these market-capitalization weighted price indices using daily returns based on Bloomberg values (BVAL) for the Puerto Rico bonds from June 30, 2012 to December 31, 2015. We exclude zero-coupon bonds and pre-refunded bonds. The insured PR bonds include those bonds insured by Assured Guaranty, National Public Finance Guarantee Corp (MBIA), AMBAC, Fannie Mae, Freddie Mac, Ginnie Mae, etc. The Puerto Rico bonds insured by FGIC are included in the uninsured category, not the insured category because FGIC’s insurance wrapper became effectively worthless after 2008.

Figure 1: Insured and Uninsured Puerto Rico Bond Indexes 2012- 2015.

The difference between insured and uninsured bond values is striking. The insured bonds are worth slightly more than uninsured bonds but the difference is small and the two indices move up and down together quite closely until the late Spring of 2013 when the underlying value of Puerto Rico bonds begins to decline significantly. At this point the insurance wrapper surrounding the insured Puerto Rico bonds protects them from further declines in value suffered by the uninsured bonds. The predictable, really intended result, is evident. While investors in uninsured Puerto Rico bonds lose over 50% of their principal value during the period plotted in Figure 1, investors in insured bonds suffer no losses at all.

In Figure 2, we plot the face value and market value of insured and uninsured Puerto Rico bonds. Our data includes approximately $50 billion face value of uninsured bonds and $10 billion of insured bonds. Again, we exclude pre-refunded and zero coupon bonds and a few bonds for which we couldn’t identify insurance status.

The pattern of losses in uninsured bonds but safety of principal in insured bonds in Figure 2 is similar to Figure 1. The market value of the uninsured bonds drop significantly while the value of the insured bonds is virtually unchanged.

Figure 2: Insured and Uninsured Puerto Rico Bond Outstanding 2012- 2015.

Coupons and Yields

Issuers pay for bond insurance because it lowers their borrowing costs. Other things equal, investors require lower yields on insured municipal bonds than on uninsured municipal bonds because they are less risky. The published literature indicates the difference in yields between insured and uninsured bonds is about 30 basis points (0.30%). This may understate the value of insurance because more risky and/or smaller issuers may choose to pay for insurance. Nonetheless, investors seem to receive about 30 basis points less per year for investing in insured versus uninsured municipal bonds.

The difference between insured and uninsured Puerto Rico bond yields is the same as for mainland municipal bonds. The weighted average coupons on insured and uninsured Puerto Rico bonds in Figure 2 were 5.24% and 5.42% on June 29, 2012. The weighted average yields on insured and uninsured Puerto Rico bonds were 4.88% and 5.19%. The weighted average maturities on were 13.5 years and 20.2 years. See Figure 3.

Figure 3: Insured versus uninsured Puerto Rico bond average coupons, yields and maturities

Investors bearing the risk of uninsured Puerto Rico bonds before the losses in 2012 and 2013 were receiving 31 basis points in additional yield but were holding bonds which had on average 50% longer maturities. The upward sloping term structure of municipal bond yields implies investors require at least 31 basis point more for holding bonds maturing in 20.2 years rather than 13.5 years assuming everything else about the issuer is identical. Thus, after adjusting for the difference in average maturities, investors were receiving no additional compensation for holding uninsured Puerto Rico bonds rather than insured Puerto Rico bonds before the losses in 2012 and 2013.

UBS Puerto Rico Closed End Fund Losses

Figure 4 reports the percentage of the UBS Puerto Rico closed end fund holdings which were uninsured and the percentage price losses in these funds in 2013, 2014 and 2015.

Figure 4: UBS PR Funds suffered losses in proportion to uninsured bonds held

Consistent with Figures 1 and 2, investors in the UBS Puerto Rico closed end funds suffered losses in direct proportion to the amount of uninsured Puerto Rico bonds the portfolios held. The UBS Puerto Rico portfolio managers chose to almost exclusively hold uninsured Puerto Rico bonds even though there was little additional compensation for holding the more risky uninsured bonds except for compensation required to cover their longer maturities and therefore greater interest rate risk.

Someone should be looking into this.

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