Buy Side

Closed-Ends Eye Auction-Rate Exit

As a means of exiting the auction-rate securities market and seeking new alternatives for cost-efficient leverage, a handful of municipal closed-end funds are in the midst of launching new floating-rate products or relying on traditional tender-option bond programs to redeem their outstanding auction-rate preferred shares.

Historically, closed-end funds - which have a fixed number of shares and trade on a major exchange - gained leverage in the ARS market. For the first time in 20 years, auctions failed starting in mid-February after bond insurance companies began to have their credit downgraded. As auction rates reset higher, closed-end fund managers saw their cost of capital rise and liquidity collapse, and were left holding a reported $63.4 billion of preferred shares.

In the aftermath, closed-end funds have been forced to seek new methods of leverage to enhance return without increasing investment. Overall, they face a lengthy transition given that they sold approximately $30 billion of auction-rate preferred shares, analysts said. To date, closed-end funds in general have reportedly redeemed 10% of their preferred shares, and expect to redeem another 15% in the coming months.

At least five major asset management companies are either in the process of launching new floating-rate securities or using traditional TOB programs to redeem preferred shares. They include Chicago-based Nuveen Investments, Boston-based Eaton Vance Management, AllianceBernstein LP headquartered in New York City, Morgan Stanley Investment Management, also in New York, and Van Kampen Asset Management, also in Chicago and a wholly owned subsidiary of Morgan Stanley.

Both Nuveen and Eaton Vance are launching their own brand of floating-rate instruments, while Morgan Stanley, Van Kampen, and AllianceBernstein are currently opting to use standard TOB programs to unwind portions of their auction-preferred shares. Such shares have first claim on dividends and assets of a fund, primary to common shares.

Nuveen's new product line is called variable-rate demand preferred shares, or VRDPs.

The new security could debut sometime later this month or as late as the end of July, pending approval from its board of trustees, according to a May 21 press release. The VRDPs would include an unconditional put feature making the product potentially attractive to money market funds, the firm said.

Eaton Vance, meanwhile, is planning to introduce liquidity protected preferred shares, which, unlike auction-preferred shares, will be supported by the unconditional purchase obligation of a designated liquidity provider, according to a May 20 press release. The preferred equity securities will pay a dividend rate, which is reset weekly based on a determination of the market clearing rate by the LPP shares' designated remarketing agent.

The firm is currently awaiting Securities and Exchange Commission approval on a no-action letter before going ahead with the LPP launch, said Jonathan Isaac, head of product development at the firm. It is also awaiting approval from its own board of trustees.

Seeking alternative forms of leverage is a necessary step toward providing liquidity at par for the existing holders of the preferred shares, analysts say. In addition, they believe the availability of increased TOB product and the debut of new floating-rate paper will bolster the volume of short-term securities available for money market funds in the wake of the ARS collapse.

"Auction-preferred shares were not money market eligible because there was no hard put," said Nat Singer, a managing director and partner at Swap Financial Group in South Orange, N.J.

"To the extent that [the new products] have a put and the funds can offer a product that is money-market eligible, they can efficiently generate leverage, and as a result additional tax-exempt yield," he said.

Tender-option bonds, also known as put bonds, are typically floating-rate or variable-rate securities that grant the bondholder the right to require the issuer - or a third party acting as agent for the issuer - to purchase the bonds, usually at par, prior to maturity or upon the occurrence of specified events or conditions, such as when the floating-rate changes.

TOBs place high-quality municipal bonds into a trust arrangement, and in exchange, each respective fund receives cash and a residual interest security issued by the trust. The trust then issues securities which are purchased by third parties, such as money market funds, and which pay interest rates that reset weekly based on a short-term index rate. The funds continue to earn the interest from the bonds that comprise the TOB trust, less the interest paid to the holders of the floaters and any fees.

As the closed-end funds seek to refinance their preferred shares and generate cost-effective leverage, Singer said they should benefit from the steepness of the municipal yield curve by buying long-term munis and financing a portion of those purchases by selling short-term tax-exempt securities.

"When the auctions failed, the rate they were paying in the auction was as much or more than the yield on the long-term bonds," he said. "So now they are looking for alternative methods of providing leverage for the funds where they can produce a positive tax-exempt, residual yield."


As firms weigh their options for redeeming preferred shares, some are planning to use a combination of new floating-rate product and TOBs.

Nuveen, which has previously used tender-option bonds for portfolio structuring and duration management, is considering using them for leverage in refinancing a "modest portion" of the $11.2 billion of outstanding preferred shares issued by its municipal funds.

Meanwhile, to support its new VRDP product, Nuveen already has two major financial institutions in place - one acting as a remarketing agent, the other providing an initial commitment of up to $1.75 billion of liquidity support for the first issuance. However, a company spokeswoman said she could not yet announce which firms were on board.

To prepare for its LPP launch, Eaton Vance is actively seeking liquidity providers, according to Isaac, who noted that the firm itself is providing a secondary backstop of up to $100 million on the first issue.

He said Eaton Vance's municipal closed-end funds have already redeemed approximately $580 million of auction-rate preferred shares of the $1.6 billion total outstanding. For that, the firm used TOBs.

The firm plans to continue to use TOBs - and potentially the new LPP product - to redeem the remaining $1 billion held by its municipal closed-end funds. But Isaac said the initial issuance of LPP shares may not be used to redeem auction-preferred shares until the securities have been proven to work effectively.

Meanwhile, three of AllianceBernstein's closed-end funds were to begin redeeming partial shares this week and next, according to information in a May 19 press release from the firm. Its national municipal income fund, the New York municipal income fund, and the California municipal income fund were each expected to redeem, two days before the June 9 dividend payment date, a portion of Series T preferred shares of $39.6 million, $4.2 million, and $4.2 million, respectively. The shares were to be redeemed at a price of $25,000 per share, plus accumulated but unpaid dividends.

Calls and e-mails to AllianceBernstein seeking comment were not returned.

Van Kampen and Morgan Stanley said in separate press releases that they have no specific timetable for the redemption of preferred shares and that the process will take place "over a period of time."

As of early May, Van Kampen's board of trustees approved the use of TOBs to refinance a portion of outstanding auction-preferred shares - up to 20% - held by 13 different municipal closed-end funds.

Back in late April, Morgan Stanley's board of trustees approved the redemption of up to 30% of preferred shares issued by 10 of its municipal funds.

The implementation and use of TOBs will rely on a number of factors, , according to information in the Van Kampen and Morgan Stanley releases. They include the availability of high-quality municipal bonds at certain yield levels to be transferred to the TOB trust structure, the ability to secure liquidity providers for the put feature, and the general market demand for the floaters.


Despite the fact that the municipal market has been scarred by recent turmoil, analysts say the timing of the transition will fill more than one void in the tax-exempt money market arena.

"If anything, money market funds have gotten cash inflows as a result of the market turmoil, and at the same time, they have seen the supply of available product diminish," said Swap Financial's Singer. "There is such a supply-demand imbalance that money market funds are hungry for the product."

Since closed-end funds have previously used TOB programs for leverage, analysts say the strategy has a proven track record that should be well-received by money market funds and other qualified institutional investors.

"This is just a small twist on existing money-market eligible products. The twist is that these putable, floating-rate securities are being generated by the closed-end bond funds rather than a municipality or a proprietary trading account," Singer said.

Analysts say two of the biggest hurdles going forward are finding liquidity facilities to support the put options on the TOBs and new floating-rate products, and improving recently weak performance of the closed-end funds.

"Gaining leverage through the use of ARS proved to be inefficient over the past two quarters, but after the transition from auction-preferred to a money market-eligible security, the efficiency should come back,'' Singer said.

Matt Fabian, managing director and municipal analyst at Municipal Market Advisors in Westport, Conn., agreed that there is some precedent for success, but TOBs could shift more risk to the common shareholders.

"The funds' leverage is now more dependent on money market acceptance," he said. "By allowing the money markets to put the securities back, the trust takes the risk of being forced to de-lever."

One of the other hurdles has been the availability of high-quality bonds for closed-end funds' use in their TOB programs. "Funds hunting for high-grade paper is driving up municipal benchmarks and prices," Fabian said. "Their ability to secure this paper will drive the money market investors' response" once the new securities debut.

At the same time, he addedd, restoring liquidity to preferred shareholders is a step in a positive direction. "I think the money markets will buy [the new debt] if the underlying ratings are good enough," Fabian said.

Others believe the funds could have a tough time securing affordable liquidity providers given the weak overall economy.

"Funding is tight all over and banks are limited with their credit, so now it will cost more to get credit than in the past," said Peter Delahunt, national institutional sales manager at Raymond James & Associates Inc. in New York City.

Overall, Delahunt said, closed-end funds trying to find an escape from the turmoil in the ARS market should benefit from the surge of cash currently pouring into money market funds when it comes to their new product offerings and TOB programs.




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