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No One Likes a Failure...
Since many asset management firms do not offer closed-end funds ("CEFs"), you may not be following the mess that is going on with "failed" auctions in the municipal bond market. Here is my take:
Auction-rate securities have long been a way to offer borrowers a way to finance for the long term at short-term interest rates that are periodically reset at auction. Investors have recently soured on this part of the market, due to concerns about a lack of liquidity and questions about the bond issuers.
What is a failed auction?
When there are not enough buy orders to meet the quantity of sell orders, the auction fails. A failed auction doesn't necessarily mean a loss of capital will occur, but rather that a seller cannot sell in the auction.
So what?
When an auction fails, the issuer is typically required to pay a maximum (or penalty) rate. The maximum rate typically can be either a relatively high fixed rate, such as 10%, or a formula-based rate.
What does this mean?
As a result of failed auctions, the cost of leverage for common stock CEF shareholders has increased to the maximum rate until there is a successful auction. This can contribute to a reduction in net investment income available to fund shareholders and lead to fund dividend cuts. Additionally, the issuer sees their interest costs soar.
While the failed auctions do not directly affect the securities held in CEFs or the ability of the common stock shareholders to sell their stock, the higher cost of leverage is a serious problem and liquidity for preferred stock shareholders is impacted.
What's next?
Just today, the Securities Industry and Financial Markets Association asked the SEC to allow those who issue debt to buy it as a short-term fix. As the agency evaluates concerns about whether a borrower's participation in setting the clearing bid in an auction for its own debt would be market manipulation, CEF providers are scrambling for both short- and long-term solutions.
While the resolution is still foggy, it does seem like capital is harder to come by than it has been in a long time -- and this isn't likely to change in the near future. As this all sorts itself out, I wouldn't be surprised to see providers of CEFs take a variety of steps, some which may seem drastic today:
- Many firms are already looking to new partners for liquidity (banks, insurance firms, etc.)
- Some companies may delever funds and redeem preferred shares
- Some CEF providers may even be forced to liquidate some of their funds