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, 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.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.