Many investors wonder what to do when a closed-end fund undergoes a rights offering. These offerings dilute existing shareholders that do not exercise the rights, since they add shares outstanding and the offering price is usually at a discount to the current market price.
The Credit Suisse High Yield Bond Fund (DHY) recently held a rights offering that just expired on October 15. Existing shareholders were offered the right to buy one new share for every three shares they already owned. The new shares are being sold at a 7.5% discount to the market value determined by averaging the closing price for five days leading up to October 15.
For example, suppose you owned 3000 shares of DHY which closed on Friday at $2.93. The 3000 rights entitle you to purchase 1000 new shares of DHY at a price of approximately $2.72 (which is 0.925 times the five day average of the closing prices from Oct 11 through Oct 15). These rights were tranferrable and traded on the secondary market for several weeks. The rights generally traded for about 6 cents each. The “fair value” of the rights is about 7 cents, since three rights give you a discount of about 21 cents a share based on the current price.
These rights offerings provide good opportunities for larger, more sophisticated investors, but in some ways are unfair to small investors because:
- They provide a way for closed-end funds to raise additional money without paying a large underwriting fee, but they are somewhat coercive, since they force shareholders to participate or face significant dilution.
- Most small investors who exercise their rights have to pay a “corporate reorganization fee” of $30 to $50 which wipes out any advantage they may get.
- Small investors who sell their rights pay a commission which can be a large portion of the value received.
For example, suppose a small retail investor owned only 300 shares of DHY. They would receive 300 rights that sold for about 6 cents each, so the investor would only receive about 18 bucks minus commissions on a sale. If they exercise the rights, they can buy 100 new shares at $2.72, but the corporate reorganization fee of $50 would make the total cost of the new shares $3.22 which is no bargain.
What happens to the shares from rights that are not exercised by smaller investors? There is an oversubscription option, where investors that do exercise their rights can oversubscribe for additional shares at the discounted price. This is where larger, more sophisticated investors can get an edge.
I purchased some blocks of DHY rights when they were available at discounted prices. In order to keep the commission cost down, I try to purchase rights in fairly large size- at least 9,000 share lots or more. It will be interesting to see how DHY trades next week. The NAV will drop somewhat because of the share dilution. But DHY is currently trading at a small discount to NAV, while it sold at a 10% premium a few months ago. Quite often, the premium re-establishes itself a few months after the rights offering is completed.
There was a similar rights offering earlier this year in PFN. Bill Gross purchased 49,291 shares using rights he obtained as a shareholder. He also oversubscribed for 1,000,000 shares and received 255,908 additional shares at the discounted price, or about five times as much as from his original rights. This shows that oversubscription can be quite profitable, but you need to have significant excess cash funds available in your account.
Full Disclosure: Long DHY.