Short-term interest rates near zero are a bonanza for the closed-end fund industry. If only they lasted forever.
Recognizing that the Federal Reserve’s target for short-term rates scraping zero is likely fleeting, closed-end funds have been replacing their leverage to lock in spreads while they can.
While municipal closed-end funds have been restructuring less than other classes of funds, some complexes — most notably Nuveen Investments — have been redeeming their auction-rate preferred shares and replacing them with other types of leverage that can withstand a spike in short-term rates.
Municipal closed-end funds are investment vehicles that raise cash through an initial public offering and invest it in state and local government debt.
At the end of last year, closed-end funds owned $77.9 billion of municipal bonds, according to the Investment Company Institute.
Leverage is the key distinction between closed-end funds and other muni investment vehicles. Closed-end funds’ shares trade publicly and cannot be redeemed. That enables closed-end fund managers to borrow money to supplement the cash raised in the IPO.
The borrowed money is also invested in munis, and the coupon collected on the bond in excess of the interest paid on the borrowings is spread income for the fund.
The most common source of borrowing for muni closed-end funds for years has been auction-rate preferred shares.
ARPS are securities whose interest rates reset regularly at an auction.
Because investors in the past typically held ARPS for only a few weeks or months before the next auction, the product usually auctioned at low interest rates.
If an auction fails, the rate resets to a penalty rate — commonly a multiple of the London Interbank Offered Rate.
These auctions began failing in February in 2008, saddling investors with the ARPS with rates pegged to Libor.
With three-month Libor at 0.25%, according to Bloomberg LP, the ARPS “penalty” rates are minuscule.
Consider Van Kampen Investments, which runs a dozen municipal closed-end funds.
The firm’s biggest muni fund, the Trust for Investment Grade Munis, owns $1.28 billion of municipals. About $400 million of those were purchased with money borrowed through ARPS.
Van Kampen is only paying 0.14% on most of the ARPS the fund issued. Everything it collects on the municipal bonds it bought with the borrowed money in excess of that yield is gravy for shareholders.
It may therefore seem puzzling that funds would redeem their ARPS and replace them with higher-yielding securities.
Of the $63.9 billion in closed-end ARPS outstanding before the financial crisis, $37.15 billion have been redeemed, according to Thomas J. Herzfeld Advisors.
Most of those redemptions have been exercised by taxable funds that have access to other sources of short-term financing such as bank lending.
Of the $30.8 billion in tax-exempt closed-end fund ARPS outstanding before the crisis, $9.8 billion has been redeemed.
Nuveen, the biggest muni closed-end fund manager with roughly 100 funds, has redeemed nearly $3 billion of that.
The Chicago-based company has replaced these ARPS in part with MuniFund Term Preferred Shares, which mature in five years and pay interest ranging from 2.65% to 2.95%.
Why would Nuveen opt to stop paying 0.35% on ARPS and instead pay nearly 3% on a new type of security?
The rate paid on the MuniFund Term Preferred Shares is fixed for the five-year life of the security.
If Libor goes up, the rate on the ARPS will go up along with it. The fixed-rate leverage offers Nuveen protection against that eventuality.
“You’re trying to lock in a known cost,” said Anne Kritzmire, managing director of closed-end funds at Nuveen who added that plenty of investors have asked why the company is switching out of cheaper leverage in favor of costlier borrowing.
Kritzmire conceded the tactic could well backfire if rates remain low for too long. In the long run, though, the company thinks this will save more than it loses.
The company last month said it had issued $620 million in MuniFund Term Preferred Shares and could issue as much as $1.3 billion. Nuveen also said it plans this year to sell $2.5 billion in variable-rate demand preferred shares.
Nuveen introduced VRDPs, which are securities with regularly resetting rates that require a credit guarantee from a bank, in 2008.
The credit crisis hamstrung the product, but now that letters of credit are available again Nuveen has resumed its development.
Maury Fertig, chief investment officer at Relative Value Partners, said he sees some wisdom in diversifying financing sources as a shield against higher rates.
Libor could easily drift up to 3% or 4%, Fertig said. In that case, these funds would be paying so much on their ARPS that the leverage would no longer make sense.
By setting a rate under 3%, Nuveen shelters part of its closed-end fund suite from the specter of higher rates.
“At least they know they’ve locked in a nice earnings spread on some of their portfolio,” Fertig said.
Fertig, whose firm manages about $450 million, said closed-end funds have another motivation for redeeming ARPS.
Most ARPS are now owned by brokerages that agreed to buy them back from clients under settlements with regulators.
By taking the ARPS off their hands, Fertig said the fund complexes can keep the brokerages happy.
If closed-end fund investors object to refashioning fund structures into costlier leverage, they have not shown it.
The First Trust Advisors index tracking returns in the sector climbed 0.4% in February and is up 2.4% on the year. The index surged 34% last year, though it is still below its peak before the crisis.
On Jan. 29, Nuveen announced that three of its state funds — one each in Ohio, Arizona, and New Jersey — would sell MuniFund shares to reshuffle its leverage.
None of the funds sold off, and all three are higher today than they were the day of the announcement.