Closed-End Fund Leverage: Failed Auctions, Fictions and Truths

The entire closed-end fund market hit an unexpected bump recently as numerous weekly auctions failed. In this commentary, we will describe a "failed auction" and how it impacts the common shareholder and a closed-end fund overall.

How Auctions Work and How an Auction Fails

Example 1 illustrates an auction scenario in a previous piece titled "The Use of Leverage in Closed-End Funds." In this example of a "successful" auction, the number of potential buyers exceeded the number of potential sellers.

click to enlarge

To help you understand a "failed auction," let's take this example a step further. In the new example 2, neither Potential Holder E nor Potential Holder F submitted a bid to buy shares. We have a seller of 250 shares (existing Holder A needs to liquidate) and only one new potential buyer (Holder D). Holder A wants to sell 250 shares but Holder D only needs to buy 100 shares. So what happens? In the past, the lead broker in the auction (typically, the lead underwriter in the offering of the auction rate securities) would step in and "back stop" the auction. In other words, the lead broker would buy the excess supply in order to clear the auction and thus prevent a "fail."

click to enlarge

There was a new wrinkle this past week, however, as the lead brokers of many auctions failed to step in and "back stop" the auctions, which consequently led to "failed" auctions.

In the event of a failed auction, most—if not all—closed-end funds have put in place a maximum rate. This rate is typically based off a "reference rate," a rate that the auction rate may track multiplied by a factor of the rate.

Fictions and Truths

Fiction: You can't get your money out. 
Truth: Auctions will continue to be conducted weekly. The ability to sell shares will be based on the number of buyers who submit "good" bids to buy at the auction. In many instances this week we have seen shares change hands, however, on a pro-rata basis.

Fiction: The funds have inherent problems. 
Truth: This is a liquidity issue brought about by the need for liquidity in the general auction rate market. This need for liquidity overwhelmed the lead brokers access to capital which forced them to step away from the auctions. It is not a credit issue.

Fiction: The maximum rates are double or triple more recent rates. 
Truth: While this may be true for some of the municipalities mentioned in articles this week by the press, in the closed-end fund market most funds do not face onerous maximum rates.

Fiction: Failed auctions may result in downgrades from rating agencies. 
Truth: The truth is that while rating agencies are monitoring the situation, a liquidity issue does not trigger a downgrade. Rating agency guidelines are driven by the ratings or valuations of the underlying fund portfolio. Net asset values in many funds over the past few days have moved higher as the general markets have rebounded.

Disclosure: None