Closed-end funds often use leverage aggressively. The essentially fixed portfolio size allow closed-end fund managers to perform tricks that funds with daily in and outflows would find difficult. A closed-end fund with $1 billion in actual shareholder capital can, for example, borrow another $500 million and buy a total of $1.5 billion in investments for the portfolio - money the closed end fund generally invests in bonds and other higher yield securities.
One reason this strategy can pass the laugh test (why borrow money and pay interest only to buy other bonds?) is the funds can borrow at very low interest rates (far lower than rates charged to retail investors using margin in their brokerage accounts) by issuing "auction rate preferred" securities.
Preferred securities means the payments of interest are senior to mere fund shareholders. Basically a fund with $1 billion says we want to borrow $500 million and we are using the fund holdings as collateral. Institutional investors bid on the preferred securities. These auctions are held frequently - weekly even - so the securities themselves are essentially floating rate investment grade bonds.
Big time institutional investors love investment grade floating rate debt. They don't have to worry about defaults or interest rates spiking - the two main fears of bond investors. This meant closed-end funds could borrow at ultra-low interest rates, then buy higher-risk, higher-yield bonds in their portfolios.
Apparently this love affair ended rather dramatically sometime around Valentines Day:
Some top U.S. asset managers that offer closed-end funds are warning their investors of lower returns as the credit crisis has severely disrupted trading this week in an instrument they rely on to borrow and boost fund returns...
...This [past] week, the auctions failed as the institutional and wealthy individual investors that usually snap them up have stayed away due to growing concerns about the credit markets."
Now many closed-end funds are finding their borrowing costs increasing right around the time when what they bought with the borrowed money - higher-risk debt - is having problems. Coming soon: lawsuits against brokers who sold (with built in sales commissions) to yield-hungry investors supposedly safer closed-end funds at $20 a share a couple of years ago; funds that are now tipping the scales at around $13 (and falling).
Crickets Heard At Closed-End Fund Debt Auctions
Closed-end funds often use leverage aggressively. The essentially fixed portfolio size allow closed-end fund managers to perform tricks that funds with daily in and outflows would find difficult. A closed-end fund with $1 billion in actual shareholder capital can, for example, borrow another $500 million and buy a total of $1.5 billion in investments for the portfolio - money the closed end fund generally invests in bonds and other higher yield securities.
One reason this strategy can pass the laugh test (why borrow money and pay interest only to buy other bonds?) is the funds can borrow at very low interest rates (far lower than rates charged to retail investors using margin in their brokerage accounts) by issuing "auction rate preferred" securities.
Preferred securities means the payments of interest are senior to mere fund shareholders. Basically a fund with $1 billion says we want to borrow $500 million and we are using the fund holdings as collateral. Institutional investors bid on the preferred securities. These auctions are held frequently - weekly even - so the securities themselves are essentially floating rate investment grade bonds.
Big time institutional investors love investment grade floating rate debt. They don't have to worry about defaults or interest rates spiking - the two main fears of bond investors. This meant closed-end funds could borrow at ultra-low interest rates, then buy higher-risk, higher-yield bonds in their portfolios.
Apparently this love affair ended rather dramatically sometime around Valentines Day:
Some top U.S. asset managers that offer closed-end funds are warning their investors of lower returns as the credit crisis has severely disrupted trading this week in an instrument they rely on to borrow and boost fund returns...
...This [past] week, the auctions failed as the institutional and wealthy individual investors that usually snap them up have stayed away due to growing concerns about the credit markets."
Now many closed-end funds are finding their borrowing costs increasing right around the time when what they bought with the borrowed money - higher-risk debt - is having problems. Coming soon: lawsuits against brokers who sold (with built in sales commissions) to yield-hungry investors supposedly safer closed-end funds at $20 a share a couple of years ago; funds that are now tipping the scales at around $13 (and falling).
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