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President's Corner

The Current Liquidity Issue with ARPs

February 28, 2008

Tom Dinsmore
Portfolio Manager
Bancroft Fund Ltd, Ellsworth Fund Ltd. President, Closed-End Fund Association

The Closed-End Fund Association (CEFA) is the trade association for the closed-end fund industry, dedicated to fostering greater awareness and understanding of closed-end funds. While CEFA is concerned about recent events in the auction rate preferred market, we do not have regulatory or other authority over management companies to help resolve liquidity issues. However, CEFA is dedicated to providing information to investors on the auction rate preferred market as they develop and here is what we know as of now.

One form of preferred shares issued by closed-end funds has been affected by liquidity issues created by the turmoil in the credit markets. Auction Rate Preferred (ARP) shares are investment instruments often used to provide leverage for some closed-end funds. They are designed to provide high levels of protection of both principal and interest. To provide this protection they are required by law to have 200% asset coverage of the amount outstanding or the fund issuing them must call them in whole or in part. This means that there are at least $3 of assets for every $1 of preferred outstanding. Many investors have successfully used these instruments in their portfolios for many years.

The current liquidity issue with ARPs is directly related to the suspension of auctions. Purchases and sales of ARPs are usually done through a Dutch auction that occurs periodically (anywhere from 7 to 35 days apart). Since there is only a rudimentary non-institutional secondary market for these issues at this time, selling (or buying) these shares in between successful auctions would likely incur substantial transaction costs. An electronic trading platform designed for institutional buyers and sellers has announced that it will be prepared to trade these securities in March, but it is not available yet. Up until the recent liquidity issues surrounding credit markets, banks (as remarketing agents) would usually fill in at auctions if there are insufficient buyers. At the most recent auctions demand from investors was insufficient and the remarketing agents did not step up to fill this gap. To my knowledge, this has not happened before.

It is important to note that a failed auction for a closed-end fund is not a default. Preferred shareholders continue to receive dividends according to their fund's prospectus. When these auctions fail, the issuer is bound by the prospectus to pay a penalty interest rate. This rate is usually set at some premium above another recognized short term rate such as commercial paper or LIBOR. Since this is only a liquidity event and does not affect the assets backing these shares, the maximum rate would, under normal circumstances in normal times, be likely to draw in institutional buyers. These are not normal times.

In talking to member fund groups during the last week, I have become aware that some managers are actively exploring their alternatives to help improve the liquidity of their issues. Several firms are in discussions with their remarketing agents to provide the backstop needed to make the auctions a success. A major issuer of closed-end funds has indicated a willingness to allow for pro rata sales of shares in their auctions that are not 100% successful. In each case, however, it is up to the individual management firm to respond since they have a fiduciary duty to both the preferred shareholder and the equity shareholder. Further, differences in the prospectus and the fund backing the preferred require individual rather than group responses to this event.

Common shareholders have generally benefited from the extra yield generated from the difference between the cost of the preferred dividends and the extra income generated by the investments. There is an implication that the potential higher cost of this leverage could have the effect of reducing income available to the common shares of leveraged funds which would be an important consideration before any of these issues are refinanced.

In summation, the principal and interest of these shares are covered by the assets of the fund that issued the shares and those who can ride out this period of illiquidity have reason to believe that they will eventually be paid in full. This is the only time I am aware of that these auctions have failed widely. Managers, their boards, underwriters and remarketing agents are reviewing alternatives to solve this problem. I anticipate that alternative sources of liquidity will develop as potential buyers become aware of the quality of these issues.

Tom Dinsmore
President,
Closed-End Fund Association