WASHINGTON - Morgan Stanley announced Monday it will refinance illiquid auction-rate preferred shares with tender options bonds, created from municipal securities in 10 of its closed-end municipal funds, to escape high interest rates and provide liquidity to its auction-rate securities investors.
The move represents a trend among close-end municipal funds: replace the high interest, auction-rate preferred shares the funds use for leverage with tender option bonds or variable-rate demand preferred shares.
As interest rates for all classes of ARS have soared since the markets froze in February, the funds are looking to escape "severely punitive" interest rates by refinancing, said Kevin O'Connor, managing director and head of the auction-rate desk at SecondMarket Inc. in New York, which specializes in trading illiquid securities.
"The issuer again is financing a long-term bond portfolio with a short-term dividend that exceeds what they are taking in on the fixed rate," O'Connor said. Interest rates for some municipal fund ARPS have reset above 12%, according to a research note published on Sept. 28 from Thomas J. Herzfeld Advisors Inc., a close-end fund research firm in Miami.
However, the refinancing options do not look attractive amid the current liquidity crisis. One of the main indexes used in the variable-rate alternatives - the SIFMA municipal swap index - surged to 7.96% on Sept. 24. Refinancing to escape the cost of ARPS may ultimately cost the close-end funds and lower their performance.
"With how things have gotten so disjointed in the short term, right now it is not a very attractive option to issue any of those if the way your deal is structured is tied to a tax-exempt index," O'Connor said.
The refinancing process enables funds to redeem outstanding ARPS to investors at par. The funds raised money for leverage by issuing ARPS and selling them to a group of investors not necessarily associated with the close-end fund.
Nuveen Investments LLC announced in August it would redeem $596.9 million of auction-rate preferred securities using TOBs created from munis in four of its close-end municipal funds. Federated Investors Inc. and Eaton Vance Corp. made similar redemption announcements in August. About $26 billion of ARPS have been redeemed this year, according to Herzfeld Advisors.
"This is an on-going trend," said Cecilia Gondor, executive vice president with Herzfeld Advisors. "In the last couple of weeks, because of the economic crisis, short-term rates have gone up very dramatically, so they're kind of in a delicate position where in the short term they may not be earning enough on the trusts to pay the rates."
Most taxable and tax-exempt close-end funds use leverage - a means of enhancing a fund's net asset value. Leverage relies on the historical fact that short-term interest rates tend to be lower than long-term interest rates. The funds use leveraging instruments, like ARPS or TOBs, to pay investing costs with short-term rates while buying long-term rates, like 30-year municipal bonds. Leveraging is only profitable when the short-term instrument's interest rate is lower than the long-term investment.
About 95% of close-end municipal funds use leverage, according to Herzfeld Advisors.
TOBs, also known as put bonds, hold fixed-rate municipal bonds in a trust. They use the bonds as collateral to sell floating-rate debt. Buyers of the floating-rate debt accept a lower interest rate because they have the option to sell the debt back to the trust.
Tender option bonds generally are not used as the sole form of leverage in a close-end fund. In the Morgan Stanley funds, TOBs will account for 50% of leverage after refinancing.
Most taxable and tax-exempt funds had not used TOBs for leverage until this year. The number of funds using thems as leverage jumped to 34.05% in 2008 from less than 1% in 2007, according to Herzfeld Advisors. TOBs are now part of the leverage mix in 159 close-end municipal funds, making it the second most used form of leverage, according to Herzfeld Advisors.