Investment Strategies

Finding value in the ARS wreckage

MuniFund Term Preferred Shares is one way to refinance collapsed auction-rate securities

Apr 25, 2010 @ 12:01 am

By Patrick W. Galley

Many investors are all too familiar with auction-rate preferred securities. For those who aren't, auction-rate preferred shares are a senior class of stock issued by a closed-end fund. Closed-end funds issue primarily auction-rate securities to create leverage, with the goal of boosting the yield and total return to the common shares.

Auction-rate securities are typically rated triple-A and pay dividends at a floating rate that in most cases resets weekly, pursuant to a Dutch auction process. Although auction-rate securities often have a perpetual duration (stated clearly in the prospectus), many investors erroneously considered these securities to be weekly money market investments because the regular auctions provided them with liquidity to sell their shares.

Beginning in February 2008, the roughly $64 billion of auction-rate securities issued by closed-end funds began to experience widespread auction failures, and there hasn't been a successful auction since. As a result, investors in auction-rate securities have limited liquidity unless they sell at a discount to par, their brokerage firm agrees to purchase back the securities or the closed-end fund redeems the securities — most likely due to refinancing.

To date, almost 60% of the outstanding auction-rate securities have been redeemed.

With more than $25 billion still outstanding, some closed-end-fund sponsors have been refinancing the outstanding auction-rate securities aggressively to provide liquidity to the holders. One of the most aggressive firms is Nuveen Investments LLC, which has been on a tear recently — successfully launching MuniFund Term Preferred Shares to refinance auction-rate securities issued by their municipal bond closed-end funds.

The MTP is a fixed-rate form of preferred stock with a mandatory redemption period, in most cases five years. It offers investors an attractive tax-exempt yield, most recently near 2.65%, and liquidity within five years.

For the fund issuing the MTP, a low historic yield is locked in for about five years, taking advantage of current historically low interest rates.

The investment case for these newly issued MTPs is compelling for those investors seeking tax-exempt income.

For starters, the tax-exempt yield is attractive, relative to other tax-exempt options and Treasuries. Five-year triple-A-rated muni general-obligation bonds now yield about 1.9%, almost 30% less than the MTP yield.

On a tax-equivalent basis, the MTP yield is about 4.1%; five-year Treasury bonds yield 2.55%.

Each MTP is backed by a diversified pool of muni bonds and, per the Investment Company Act of 1940, the required asset coverage is 2-to-1, meaning for every $1 of outstanding MTPs, the fund must maintain $2 of assets.

This strong asset coverage results in a high-quality triple-A rating.

MTPs also have medium-term maturity. The mandatory redemption in five years gives investors a limited-duration security, ideal for those concerned about interest rates' increasing.

In addition, as an exchange-traded security on the New York Stock Exchange, MTPs offer daily liquidity to investors typically within 30 days of issuance, as well as the ability to sell the security above or below par, depending on secondary-market demand. To date, all Nuveen MTPs are trading above their $10 par value, an indication of strong secondary demand and contrary to the equity of a closed-end fund, which typically trades at a discount.

Why aren't all fund sponsors issuing MTPs or similar securities?

The MTP yield is about five to six times that of the ARS current yield. Because of this increase in cost of leverage, the equity holders of the closed-end fund bare the increased cost.

Long-term equity holders who believe that short-term rates will rise sharply in the near term should welcome the issuance of MTPs.

Obviously, some fund sponsors, such as BlackRock Inc. and Pacific Investment Management Co. LLC, don't share that view, as both firms have been reluctant to using alter- natives to refinance outstanding auction-rate securities. Their case is valid from the perspective that either the fund must take on increased-interest-rate risk or credit risk, or be in the position of earning a negative carry, until yields increase enough to out-earn the cost of leverage.

Patrick W. Galley is the chief investment officer of RiverNorth Capital Management LLC. The firm specializes in quantitative and qualitative closed-end-fund strategies, and is the investment adviser to the RiverNorth Funds.

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