By George W. Karpus
The Daily Record Newswire
Lack of common sense is the nice way to comment on Standard & Poor and Fitch’s recently proposed methodology changes, which would potentially tighten its ratings criteria and likely result in ratings downgrades for some closed-end funds’ Auction Rate Preferred Securities.
The primary reason that the agencies cite for the possible downgrades is the desire to establish a minimum liquidation horizon for certain asset types to address potential risks represented by forced liquidation of short time periods.
This simply does not make sense.
Firstly, many of the remaining ARPS on closed-end funds are in closed-end municipal bond funds, which have a minimum asset coverage requirement of 200 percent. In many cases, the coverage ratio exceeds 300 percent.
In other words, there must always be at least two times the amount of marketable bonds backing the ARPS issued by closed-end municipal bond funds.
For example, if a closed-end fund were to have $50 million in outstanding ARPS, it would be required to maintain total assets of at least $100 million at all times. I challenge you to find another investment where you have a minimum of two times — and often three times — the collateral as your actual investment.
Further, the Investment Company Act of 1940 provides a safeguard to closed-end fund shareholders if closed-end funds’ asset coverage falls below the 200 percent minimum. The 1940 Act requires a closed-end fund to suspend common share dividend payments and would also result in a fund simultaneously refinancing or redeeming a portion of outstanding ARPS to increase the ratio to required levels.
Going back to our previous example, if total assets dropped to $80 million, the fund would be required to redeem $10 million of ARPS. Thus, total ARPS would be reduced to $40 million, while still having 200 percent asset coverage.
Even with the credit markets in disarray in December 2008, liquidity typically was not a problem for many closed-end funds because investors still had the required 200 percent collateral backing the ARPS. In fact, this safeguard was only triggered in a relatively small proportion of closed-end funds during the credit crisis.
Given these factors about closed-end fund ARPS, the absurdity of the rating services’ proposed logic becomes even more apparent when you compare ARPS issued by closed-end funds against prime mortgage pools on residential housing. Mortgagors typically put down 20 percent plus the housing value as collateral. Thus, if the value of the home drops by only 20 percent, then the mortgagee or other investor would only have the home as collateral. Further, in 30 out of 50 states, it takes one year or more to foreclose on a home once the mortgagor stops paying the mortgage.
From the viewpoint of statutory safeguards as well as asset coverage, it is my professional opinion that ARPS of closed-end funds are one of the safest securities an investor can buy.
If ARPS of closed-end funds get an A rating, then prime mortgages should be rated C. Following this logic, most corporate bonds would also have to be downgraded (keep in mind that the assets of a corporation are much less liquid and marketable than that of municipal bonds within closed-end funds).
In my viewpoint, absurd, illogical and void of common sense better describes S&P and Fitch as ratings services with respect to their proposal to tighten ratings criteria.
Sadly, these nonsensical changes could potentially result in downgrades and higher leverage costs for levered closed-end funds.
George W. Karpus is president of Karpus Investment Management and can be contacted at (585) 586-4680.
