Corporate and municipal closed end funds have not responded normally to recent reductions in interest rates because of the general problems plaguing the industry and, additionally, because of questions about the Auction Rate Preferred Stock (APS) they use to finance short-term borrowing. (Keep in mind that nearly all corporations and municipalities use debt financing and that such financing is not, in and of itself, a bad thing.) APS in effect resets the interest rate the borrower pays every seven to twenty-eight days. The preferreds are mostly purchased by banks, but may also be sold to individual investors. The credit crunch that originated with the sub-prime problem has spread to the APS market as well. Consequently, CEF managements now have a higher cost-of-carry on short-term borrowing.
APS issues include maximum interest rates that are generally well below the amounts the funds receive from their holdings, and all Closed End Funds can raise new capital by selling additional shares of stock. As long as the earnings generated by the assets in the portfolio continue to exceed the costs of the APS financing, such financing is beneficial to the shareholders. Should the cost approach the revenue, the manager can simply redeem the APS and reduce the holdings in the portfolio.
To alleviate the problems, central banks worldwide have injected billions to help ease tight credit conditions. Ours has slashed the Fed Funds rate to lower borrowing costs and to ease general credit conditions; more rate cuts are expected. Unlike the quality issues in the sub-prime mortgage market, the weakness in the corporate and municipal CEF markets is a more solvable liquidity problem. Historically, the easing of interest rates and injection of reserves into the system eventually move credit markets toward normal conditions. The Fed Funds rate now stands at 3%, down from 5.25% a few months ago. In 2003, the rate moved to 1% as the Fed liquefied the credit markets after 911; there is still a lot of rate cutting room in the system.
Investors would fare better if they could learn to think long-term in the face of short-term problems. This is not the first, and certainly not the last, dislocation in the financial markets. The Treasury Secretary and the Federal Reserve Chairman have testified that they expect economic growth to resume during the second half of 2008. The congressional stimulus package will be implemented quickly. The Fed stands ready with rate cuts and will inject additional reserves if needed. Typically, credit crunches with or without stock market corrections have proven to be investment opportunities. This one will be no different.
Just Another Credit Crunch?
Many investors are beginning to think that income investing is every bit as risky as equity investing, but nothing has really changed in the relationship between these two basic building blocks of corporate finance. What has changed in recent years is the nature of the derivative products created by the wizards of Wall Street to deliver both forms of securities to investors.
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Credit Crunch? - Part 1 <--
