Putnam Investments last week delayed the mergers of four municipal bond funds, saying turbulent markets have rendered the plan imprudent for now.
The money manager last year devised a plan to address the travails of two closed-end muni funds: Municipal Opportunities Trust and Managed Municipal Income Trust.
The funds suffered from dwindling bond values and the collapse of certain crucial financing markets. The closed-end funds raised cash by selling shares to investors, then used the cash to invest in munis.
The funds also borrowed money by selling securities known as auction-rate preferred shares - essentially loans whose interest rates reset regularly at auction - and invested those proceeds in munis, too.
The additional investment income from the invested proceeds enhanced the dividends paid to common shareholders.
The financial crisis slammed the funds with a double-whammy: their investments' values were clobbered and they were saddled with higher financing costs.
The Managed Municipal Income Trust's net asset value shriveled to $356.9 million from $436.8 million between the end of April and the end of October.
The Municipal Opportunities Trust's net assets tumbled to $434.3 million from $537.4 million in that timeframe.
The decline in asset values came just as the funds were forced to pay higher interest rates on their ARPS. As liquidity drained from the ARPS market, many ARPS auctions failed. When an auction fails, the interest rate resets to a penalty rate.
That penalty rate - which for some of the two funds' ARPS is 110% of the 30- or 60-day composite double-A rated commercial paper rate - saddled the funds with higher borrowing costs last year, eating into returns.
The funds' board of trustees in September proposed merging the Municipal Opportunities Trust and Managed Municipal Income Trust with the Tax-Exempt Income Fund and the Tax-Free High Yield Fund, respectively.
The board claimed this would eliminate the leverage in the closed-end funds and enable shareholders to cash shares in at net asset value.
That would be valuable because the shares have traded on the New York Stock Exchange at significant discounts to net asset value, at times wider than 10%.
Completing the transaction required buying back the ARPS from the closed-end funds before merging them into the open-ended funds.
Last week, Putnam said in a press release it concluded "unsettled" markets meant completing the proposal is "inadvisable."
Redemption of the ARPS had already commenced. The Municipal Opportunities Trust redeemed $166.5 million in preferred shares and has $178.9 million left. The Managed Municipal Income Trust bought back $74.5 million of ARPS and has $123.5 million remaining. Putnam decided not to pursue further redemptions for now.
Putnam still believes the plan is a good idea in the long run and expects to close the transaction "when market conditions permit."
The company did not respond to questions about why unsettled market conditions rendered the plan unfavorable.
Cecilia L. Gondor, executive vice president of closed-end fund research firm Thomas J. Herzfeld Advisors Inc., said repurchasing ARPS entails a fund selling some of the bonds in its investment portfolio to raise cash for redemptions.
Selling the bonds after the worst year for munis in decades means locking in investment losses, she said.
"You don't want to jeopardize the net asset value by selling into a market that's illiquid or where prices are under pressure already," she said. "It may make sense to just give it a little more time."
Another development since the proposal suggests it may be wise to wait, Gondor said - the "penalty" rate closed-end funds are paying after failed ARPS auctions is no longer a penalty rate at all.
The commercial paper rates the funds' penalty rates are based on are flirting with zero, reined in by the Federal Reserve's quest to slash interest rates and bolster the commercial paper market.
Failed ARPS right now are providing the funds with cheap financing, Gondor said.