Frequently Asked Questions About Closed-End Funds and Their Use of Leverage

This document contains FAQs about closed-end funds, including information related to failed auctions for auction market preferred stock.

Table of Contents

I. General Information About Closed-End Funds
II. Auction Market Preferred Stock
III. Recent Developments

I. General Information About Closed-End Funds

What are closed-end funds?

Closed-end funds are professionally managed investment companies. Closed-end funds issue a fixed number of common shares that typically are listed on a stock exchange. Once issued, a closed-end fund’s common shares are not typically purchased or redeemed directly by the fund, but instead are bought and sold in the open market.

In what types of securities do closed-end funds invest?

Closed-end funds invest in a wide variety of domestic and foreign securities, including common stocks, preferred stocks, high-yield bonds, municipal bonds, and corporate bonds.

What types of stock do closed-end funds issue?

All closed-end funds issue common stock. In addition, closed-end funds are permitted to issue one class of preferred stock under Section 18 of the Investment Company Act of 1940. Preferred stock differs from common stock in three ways:

• Preferred shareholders typically are paid dividends at a rate which is fixed for some period of time;
• Preferred shareholders have priority to income and assets of the fund in the event of liquidation; and
• Preferred shareholders do not share in the gains and losses of the fund, as common preferred shareholders do.

How many closed-end funds are there?

According to ICI data, as of the end of September 2009, there were 632 closed-end funds, with 311 having preferred shares. The total assets held by closed-end funds was $223.5 billion.

Assets of Closed-End Funds
Assets in billions of dollars

Why do closed-end funds issue preferred stock?

Issuing preferred stock allows a closed-end fund to raise additional capital, which it can use to buy more securities for its portfolio. This strategy, known as leveraging, is intended to allow the fund to produce higher returns for its common shareholders over the long term. Funds can also leverage by borrowing money or issuing debt securities. In addition to this structural leverage, some funds may employ other economic forms of leverage through certain types of investment transactions (e.g., reverse repurchase agreements, derivatives, tender option bonds). Funds invest the additional capital raised through leverage in securities that are expected to earn a rate of return that exceeds the short-term borrowing cost of the preferred stock, debt, or other leveraging instrument. The additional income, or return, is then available for the benefit of common shareholders. 

Is leverage commonly used?

According to data reported by Thomas J. Herzfeld Advisors, Inc., 70 percent of closed-end funds used some form of leverage in 2009.

Does the use of leverage present any risks for common shareholders?

Yes. The net asset value of the common shares and the returns earned by common shareholders will be more volatile in a leveraged fund than in a closed-end fund that does not use leverage. If short-term interest rates rise, the cost of leverage will increase, most likely reducing the returns earned by the fund’s common shareholders.

What type of shareholder protections do closed-end funds offer?

Closed-end funds are governed by the Investment Company Act of 1940, a law that shapes how all registered investment companies must be structured and operated. All closed-end funds must meet certain operating standards, observe strict antifraud rules, meet diversification requirements, and disclose complete information to investors. The Securities and Exchange Commission (SEC) oversees regulations under the Act.

In addition, closed-end funds are subject to asset coverage requirements if they issue debt or preferred stock. For each $1.00 of debt issued, the fund must have $3.00 of assets immediately after issuance and at the time of dividend declarations (commonly referred to as 33 percent leverage). Similarly, for each $1.00 of preferred stock issued, the fund must have $2.00 of assets at issuance and dividend declaration dates (commonly referred to as 50 percent leverage).

In addition, like all registered investment companies, closed-end funds must have a board of directors elected by the fund’s shareholders to oversee the management of the fund’s business affairs and to protect the fund’s interests, taking into account the interests of all shareholders.

Do preferred shareholders vote for fund directors?

Yes. Section 18 of the Investment Company Act provides the preferred shareholders with the exclusive right to elect two fund directors. Preferred shareholders also typically vote together with the common shareholders to elect the remaining fund directors. In addition, Section 18 provides preferred shareholders with the right to elect a majority of directors if the fund does not pay dividends to the preferred shareholders for a period of two years.

Do the directors elected by the preferred shareholders have distinct responsibilities to those shareholders?

No. Neither the Investment Company Act nor the jurisdictions in which most closed-end funds are organized (Maryland and Delaware) assign distinct duties to directors elected by preferred shareholders. Those directors, like all fund directors, owe a fiduciary duty to the fund to act in a manner that protects its interests, taking into account the interests of all shareholders, both common and preferred.

II. Auction Market Preferred Stock

What is fixed rate preferred stock?

Fixed rate preferred stock has a fixed dividend rate that is set at the time of issuance based on market conditions.

What is auction market preferred stock?

Auction market preferred stock is a type of preferred stock that pays dividends that vary over time. The dividend rates are set through auctions run by an independent auction agent. Typically, shares trade hands and dividend rates are reset through auctions held every seven or 28 days. An auction is governed by a set of procedures established by the closed-end fund and its auction agent. Typically, investors submit bids and sell orders through a broker-dealer, who, in turn, submits them to an auction agent. Auctions may have a single broker-dealer or multiple broker-dealers who may submit bids or sell orders for their own account and on behalf of customers wishing to purchase or sell the securities. Bids are filled to the extent shares are available, and sell orders are filled to the extent there are bids. All filled bids receive dividends at the new set dividend rate.

What is a failed auction?

An auction fails when there are more shares of preferred stock offered for sale in the auction than there are bids to buy shares. If auctions continuously fail, holders of preferred stock who want to sell their shares generally are not able to do so. Fixed rate preferred stock has not been affected by failed auctions.

Is a failed auction a default by the closed-end fund?

No, a failed auction is not a default. Holders of auction market preferred stock continue to receive dividends from the closed-end fund, but at a different rate.

How do closed-end funds determine dividend rates in the event of failed auctions?

In the event of a failed auction, closed-end funds pay a dividend rate based on a formula established when the shares were first issued. This rate, referred to as the “maximum” rate, is determined by reference to short-term interest rates (for example, LIBOR) and is explained in the fund’s prospectus.

What is the effect of a failed auction on preferred shareholders?

Preferred shareholders continue to receive dividends at the maximum rate but generally are not able to sell their preferred shares through the auction process. A limited number of preferred shares have traded outside of the auction process.

What is the effect of a failed auction on the fund’s investments and the fund’s common shareholders?

Failed auctions do not directly affect the portfolio securities held by funds or the ability of common shareholders to sell their stock. As the cost of leverage increases, however, the fund’s current earnings may decline.

Were failed auctions caused by any concerns about the credit quality of closed-end funds?

No. The assets of closed-end funds, which are valued on a daily basis, are the collateral underlying the issuance of the preferred shares. As discussed above, funds are required by the Investment Company Act to have at least $2.00 of assets for each $1.00 of preferred stock issued. Preferred shares typically have an AAA rating from one or more rating agencies; these ratings are based on both the asset coverage behind the preferred shares and the quality and diversification of the collateral.

Have the credit ratings of closed-end fund’s preferred stock been affected by the failed auctions?

No. To date, the credit ratings of closed-end fund preferred stock have not been downgraded as a result of failed auctions.

Why did the auctions initially fail?

Auctions initially failed because of liquidity issues (i.e., there were more shares offered for sale than there were bids to buy shares). Liquidity problems seem to have developed because some broker-dealers who customarily placed bids for their own accounts in auctions stopped this practice. Broker-dealers are not legally required to bid for their own accounts in an auction.

Why did the auctions continue to fail?

Soon after a few auctions failed, all auctions for closed-end fund preferred stock began to fail. It appears that as preferred stockholders became concerned, many sought to sell their shares. This increased the imbalance between purchases and sales, making it difficult for the auction markets to resume functioning. 

Is there a secondary market for auction market preferred stock?

Yes. One firm has been reported to be facilitating secondary market transactions in auction market preferred stock. Those shares reportedly have been traded at a substantial discount from their liquidation preference, which is the right to receive a specific value for stock if the business is liquidated. For more information on investor options in the event of a failed auction, please visit the website for the Financial Industry Regulatory Authority (FINRA).

III. Recent Developments

What are munifund term preferred shares?

Munifund term preferred shares are exchange-listed closed-end fund preferred shares that have a fixed dividend rate set at the time of issuance. Munifund term preferred shares have a mandatory redemption period of five years (unless they are redeemed or repurchased earlier). Unlike fixed rate preferred stock previously issued, munifund term preferred shares were created for issuance by closed-end funds investing in municipal bonds.

Have any closed-end funds issued munifund term preferred shares?

Yes. From mid-October 2009 to January 2010, a number of municipal bond funds have issued or announced their intention to issue munifund term preferred shares.

Are these funds using munifund term preferred shares to redeem auction market preferred stock?

Yes. Munifund term preferred shares were designed to help refinance and redeem auction market preferred stock and to maintain a fund’s leverage capital structure.

Have regulators issued relief to give funds more flexibility to replace auction preferred stock with debt?

Yes. The SEC has permitted several groups of related funds to use more debt than otherwise permitted by the Investment Company Act for the purpose of redeeming auction market preferred stock. As discussed above, funds are required by the Investment Company Act to have at least $2.00 of assets for each $1.00 of preferred stock issued and $3.00 of assets for each $1.00 of debt issued. The SEC allowed the requesting funds to temporarily apply a lower asset leverage requirement for preferred stock. This allowance enabled closed-end funds to redeem auction market preferred stock.

What is puttable preferred stock?

The closed-end fund industry is trying to issue a new type of preferred stock, puttable preferred stock, on a broad basis. As of January 2010, there have been four successful offerings by one fund group. Industry participants are developing puttable preferred stock to permit funds to redeem auction market preferred stock while maintaining leverage for the benefit of common shareholders. This new type of preferred stock alternatively has been referred to as Liquidity Protected Preferred Shares (LPP), Variable Rate Demand Preferred (VRDP), or Liquidity Enhanced Adjustable Rate Securities (LEARS). These instruments are similar, but not identical, to each other. Below is a general discussion of some of their common characteristics. 

How does puttable preferred stock compare to auction market preferred stock?

Puttable preferred stock is similar to auction market preferred stock in that it is expected to pay dividends at variable rates. It differs in how the dividend rates are set and in the provision of liquidity to avoid the problems raised by failed auctions.

Rather than being set through auctions, rates for puttable preferred shares will be set through remarketings run by one or more financial institutions acting as remarketing agents. After providing a preliminary notice of the likely dividend rate, the remarketing agents will solicit existing holders and potential buyers for indications of interest to buy or sell. The agents will then match up buyers and sellers at the lowest possible dividend rate. Bids will be filled to the extent shares are available, and sell orders will be filled to the extent there are bids. All filled bids will receive dividends at the new set dividend rate.

Issuance of puttable preferred shares also involves a third party, commonly referred to as a liquidity provider. If there are more sell orders than bids in a remarketing, the liquidity provider will be contractually obligated to unconditionally purchase all puttable preferred stock. As a result of this new feature, puttable preferred stock is an eligible investment for money market funds under SEC rules, expanding the market for these shares and decreasing the possibility of failed auctions.

Who may purchase puttable preferred stock?

Under the SEC’s guidance, only qualified institutional buyers (such as money market funds, banks, and insurance companies) will be permitted to purchase puttable preferred stock.

Is there guidance available with respect to funds issuing puttable preferred stock?

Yes. Treasury has issued guidance. 

Have any closed-end funds issued puttable preferred stock?

Yes. In August 2008, one fund group announced that four of its funds had issued Variable Rate Demand Preferred, a new type of puttable preferred stock. While other fund groups have made  public announcements regarding LPP and LEARS—both new types of puttable preferred stock—market conditions seems to have delayed additional issuances.

Can the liquidity provider sell the puttable preferred stock back to the fund?

It depends. Some agreements with liquidity providers do not give them this right. Other agreements give the liquidity provider this right if the liquidity agreement has been in place for some period of time (e.g., one year) and the liquidity provider has held the puttable preferred stock for some period of time (e.g., six months). 

Are closed-end funds considering other steps to redeem auction market preferred stock?

Yes. To redeem auction market preferred stock and retain leverage, funds obtained bank loans and lines of credit, issued tender option bonds, engaged in reverse repurchase agreements, issued extendable notes, and sold portfolio securities, among other measures. 

Are all of these options available to both tax exempt municipal bond funds and taxable funds?

No. Tax exempt funds invest in municipal bonds with interest rates that are lower—due to their tax-exempt nature—than the interest rates on taxable bonds. Fund shareholders would experience higher costs if auction rate preferred stock (the dividends on which are tax-exempt) were replaced with a fully taxable alternative source of leverage. Because dividends paid by taxable funds and all forms of refinancing involve taxable income, they do not face this imbalance between return and refinancing cost. Thus, to date, tax exempt funds generally have been more limited in their ability to redeem auction market preferred stock while maintaining current leverage ratios. Nevertheless, the industry is taking steps to find cost-effective refinancing alternatives. Munifund term preferred stock and puttable preferred stock allow tax exempt municipal bond funds to maintain their current leverage ratios (with asset coverage of 200%) and maintain the benefit of lower leverage costs by passing through tax exempt dividends). Tax exempt municipal bond funds also may partially refinance their auction market preferred stock by investing in TOBs, or by deleveraging and selling portfolio securities. 

How much auction market preferred stock has been redeemed as of December 29, 2009?

According to data reported by Thomas J. Herzfeld Advisors, Inc., funds had either redeemed or announced definitive redemption plans for approximately $37.2 billion (or 58 percent) of the $63.9 billion of auction market preferred stock that was outstanding on February 12, 2008.

February 2010