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From the Closed-End Fund Mailbag

Answers to some commonly asked questions, plus a discussion of the impact on CEFs of the recent bank downgrades. 

Cara Esser, 06/29/2012

We try to respond to every email and post from our readers, but it has been a while since we've compiled some of the most frequently questions. In addition, there was a bit of news out earlier this week that some closed-end fund, or CEF, readers had concerns about.

On Tuesday, Moody's downgraded a handful of U.S. banks and certain CEFs' Variable Rate Demand Preferred Shares. I'm a common shareholder; how does this affect me?
As the news broke early this week, it was immediately followed by an article in the Wall Street Journal entitled, "Downgrade of Funds to Have Broad Effects." We received a handful of calls from reporters about the story, and our general response was, and still is, that there isn't much of a story. Yet. To us, the WSJ article was highly sensationalized, attempting to evoke fear reminiscent of the auction rate preferred crisis in 2008. According to the article, of the 630-plus funds in the universe, the securities of 38 municipal CEFs were downgraded. That's about 6% of the entire CEF universe. A broad, rippling effect? Hardly.

Without delving too deeply into the interworkings of VRDPs, a brief discussion is in order. VRDPs are a type of preferred share issued by CEFs to create leverage. They are part of a fund's capital structure, not part of its holdings. As the name suggests, the interest rate paid on these shares is variable, typically reset each year based on a predetermined reference rate. When the shares are issued, fund families use banks to back the preferred shares by guaranteeing liquidity. This means they are contractually obligated to buy all of the VRDPs should investors wish to sell, which is a far cry from the ARPS structure. In general, the main buyers of VRDPs are institutions and money funds.

Back to the downgrades. Because money market funds are big holders of these securities, a big concern was that the downgrade would make the VRDPs ineligible for the money funds to hold. For a security to be money market eligible, it must meet certain criteria including a minimum rating from ratings agencies. VRDPs are given multiple ratings including one based on the creditworthiness of the liquidity provider (the bank). Because the banks backing the VRDPs were downgraded, the preferred shares were also downgraded. (If an insurer or guarantor is less creditworthy, so are the securities on which the firm insures or guarantees payment.)

It important to keep in mind that most VRDPs have ratings from multiple agencies, and Moody's was the only agency to downgrade the banks and subsequently these securities. As it stands, the money funds should not be required to sell any of these VRDPs simply because of this one downgrade as they still meet the basic criteria for holding. In speaking with fund representatives, the general sense is that no one is running for the door.

Of course, there are always risks. Should this become a trend of downgrades, and should the banks have real liquidity issues, common shareholders would likely be hurt by higher costs of leverage and the holders of VRDPs could be hurt if the banks are not able to provide the promised liquidity. But this is a long shot at this point.

This incident is a good reminder that, in times of uncertainty, it's important to know and trust the fund company running your CEF. And it's also a good reminder of recency bias, by which investors are liable to create a mental link between ARPS and VRDPs. A strong and investor-friendly fund family will not only diversify the type of leverage, expirations, and the rates paid, but also the counterparties through which they do business. In the case of a fund family using multiple, carefully vetted, and constantly monitored counterparties, this type of news should have little to no effect on common shareholders.

Why did you downgrade ABC fund to 3 stars from 4?
This is the question we are most often asked. We've discussed it in the past, but, there still seems to be some confusion between Morningstar's ubiquitous "Star Rating" (formally called the Morningstar Rating) and the relatively new Morningstar Analyst Rating (Gold, Silver, Bronze, Neutral, and Negative). In fact, a few weeks ago, a fairly sharp criticism was written about our ratings on certain funds. In his critique, the author consistently confused the two ratings, how they are generated, and what they mean. The reality is that these ratings are not interchangeable, are essentially unrelated, and sometimes contradict one another.

Cara Esser is a closed-end fund analyst at Morningstar.
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