GDL Fund Preferred B: Good Investment for the Risk Averse

Apr. 6.11 | About: GDL Fund (GDL)
There are some investors who are highly risk-averse. My mother definitely fit into that category. My mom never owned a common stock in her life. For many years, her only investments were in savings bank CDs, money market accounts and Series E savings bonds.
When I-bonds were introduced in 1998, it took a while for my mom to be comfortable with them, but she finally added them to her “repertoire”. I had to assure her that the principal would never decrease even if there were deflation.
My mom’s approach toward investing may seem too conservative, but it fit her risk profile perfectly. My mom passed away in 2007, but I remember thinking at the end of 2008, that her “portfolio” would have outperformed 99% of those put together by investment pros.
In the current environment, The Federal Reserve’s near-zero interest rate policy is a form of unlegislated “tax” on risk-averse investor’s like my mom. The Federal Reserve is trying to help the banking industry and the economy with artificially low interest rates. This benefits federal, state and local governments as much as a tax increase, but it reduces income to holders of government guaranteed debt. This policy decision has a big effect on the economy, but at the same time, legislators are not being held accountable for levying the country’s biggest invisible tax on savers.
One could make the case that this “tax” on savers can be avoided by simply refusing to buy US government guaranteed debt. This is technically true, but investors need an alternate place to invest their money. A riskier investment earning 6% may seem highly attractive compared to earning zero on cash, but that 6% return usually comes with volatility and risk that are unacceptable to an investor who considers preservation of capital the ultimate criteria.
Ironically, the near-zero interest rate policy may be adding to the unemployment rate. Many risk-averse baby boomers are extending their working careers. They cannot afford to retire because of the near-zero interest rates. Because of this, they keep their jobs longer that would normally, jobs that would otherwise go to younger workers. This leads to an increase in the unemployment rate since very few new jobs are being created.
Many low risk investors are always on the lookout for investments that are safe, yet can still offer a decent yield. I believe that one of the better investments in this category is the GDL Fund preferred stock B which will start trading in the next week.
The investment goal of the GDL Fund (NYSE:GDL) is to earn absolute returns in excess of short-term interest rates with much less volatility than other equity funds. They use a classic merger arbitrage strategy--shares of a target acquisition company are bought at a discount to the expected value of the shares once the merger or acquisition is completed. They try to earn the “spread” between the purchase price and the offer price for the target company.
The GDL Fund recently approved the issuance of a new series of B preferred shares through a rights offering to the Fund’s existing A preferred shareholders.These preferred shares offer leverage to the common shareholders of GDL.
The new series of B preferred stock will be issued at $50 a share and is non-callable for three years. It will have a fixed 7% dividend rate the first year. The interest rate will then float with the market and will be adjusted at year 1, year 2, year 4 and finally will be redeemed at year 7. There is a 3% interest rate floor on any rate adjustment.
Preferred shareholders will also have as “put” option to redeem their preferred shares at par ($50) after year 2 and year 4 after the issue date.
There are several reasons why I believe the GDL Fund Preferred is a safe investment:
1) Under the Investment Company Act of 1940, the minimum asset coverage for the preferred shares is 200%. The Fund’s preferred shares are expected to have an initial asset coverage ratio of 232% on the issuance date.
2) The underlying GDL Fund has been a very conservative low risk fund. Here is the NAV performance of the GDL fund for the last three years:
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In order for the GDL Fund preferred collateral to be at risk, the net asset value of the GDL Fund would have to fall by more than 50%. Even in 2008, the GDL fund only fell 2.36%. If the asset coverage ratio ever falls below 200%, the GDL Fund will not be allowed to pay out any distributions.
3) It is useful to know that Mario Gabelli has been a large shareholder of the GDL Fund Preferred A shares with his personal family money. He will most likely retain some ownership in the new B shares as well.
4) The preferred interest rate will re-set higher if we enter a rising interest rate environment, and the investor has several “put” options to redeem their money if they are unhappy with the new interest rates.
Overall, I think the GDL Fund preferred B shares are a good investment for the highly risk-averse investor who does not need day-to-day liquidity. It can also be used by other investors as a place to keep some of the cash portion of an asset allocation.

Disclosure: I am long GDL Preferred A shares and will be participating in the rights offering to buy the GDL Preferred B shares. No position in GDL.