Bond managers trading painfor long-term gain

Bond fund managers — including Eaton Vance, Pioneer and Nuveen — are stepping up efforts to redeem auction-rate preferred securities for investors, choosing to incur short-term costs rather than risk long-term damage to their franchises.

Noticeably absent from the redemption activity is Pacific Investment Management Co.

Auction-rate securities are debt obligations issued by municipalities, non-profit entities and closed-end mutual funds. Interest rates on the securities are set by periodic auctions, based on investor demand. When the credit crunch hit, the $300 billion ARPS market froze. Dealers exited the market and investors — who once believed these instruments to be almost the same as cash investments — were left with securities they could not sell.

The problem for many managers of closed-end funds is that redemptions pit the needs of their preferred shareholders against the need of the common shareholders.

To redeem the preferred shareholders, managers need to raise cash — usually through some combination of issuing debt, a letter of credit or loan and swapping out old securities for new ones. However, the cost hurts common shareholders’ return. To keep common shareholders’ return high, managers are forced to boost leverage, which is expensive in current market conditions.

Jonathan Isaac, vice president of Eaton Vance Asset Management in Boston and responsible for the oversight of all of Eaton Vance’s closed-end fund products and trading in the secondary market, said the firm was committed to enabling preferred shareholders to redeem their outstanding ARPS.

“From our standpoint, there was recognition when this crisis began, from the top of the firm down, that from a legal standpoint we were under no obligation to do anything, but from a reputation standpoint it was in our best interest to come up with a solution best situated to the (holders of) common and preferred (shares),” said Mr. Isaac.

Eaton Vance funds have redeemed approximately $3.6 billion of ARPS of the $5 billion the firm had outstanding as of February, raising cash through bank financing, commercial paper programs and tender option bonds.

Geoff Smith, head of corporate communications and spokesman for Pioneer Investment Management Inc. in Boston, said, “We want to redeem $176 million in preferred shares from six closed-end funds.” He said Pioneer officials are seeking additional financing to enable the firm to complete this redemption and redeem the additional outstanding $637 million preferred shares.

Similarly, Nuveen Investments LLC, Chicago, has redeemed $1.7 billion of ARPS in seven funds since April. It has done this by refinancing ARPS in taxable funds by issuing new debt. For non-taxable funds, Nuveen is using a combination of tender option bond trusts and a new security, the Variable Rate Demand Preferreds, tapping into approximately $500 million of up to $1.75 billion line of credit.

“We are doing as much as we can to restore confidence, as we have $50 billion in our closed-end fund business and that is important to us,” said Anne Kritzmire, managing director of closed-end funds at Nuveen. “We look at the opportunity of not doing this and you can only imagine what that could be. We have incurred manpower costs and the cost of leverage has risen, but we have to restore investor confidence.”

Newport Beach, Calif.-based PIMCO, however, remains an exception, declining to bail out preferred shareholders in ARPS that it has issued. PIMCO has $4.3 billion in outstanding ARPS; a breakout between preferred and common shares was not available.

Spokesman Mark Porterfield, when asked for comment, supplied the following statement: “PIMCO knows and understands that this is a difficult issue for some preferred shareholders, and we have been working diligently to find a solution that is consistent with our fiduciary duty to all shareholders, both common and preferred. As the subadviser to these funds, PIMCO’s role is to advise the board of the funds that alternative financing to create liquidity for the preferred must come in a form and at a price that balances the interests of the shareholders such that it does not impose unfair costs on the common shareholders.

“We are devoting considerable time, energy and attention to finding an approach that, consistent with our fiduciary obligation, reconciles the competing considerations facing common and preferred shareholders. Our top priority has always been, and will remain, to place our fiduciary duty to our clients first and foremost, and we will continue to explore all avenues to identify an appropriate and sustainable long-term response to this challenging issue.”

Challenges still remain for firms that are redeeming the securities.

For example, Pioneer officials are considering merging the $534 million Pioneer Municipal and Equity Income Trust closed-end fund — which contains ARPS — into one of its open-end funds, the $470 million Pioneer Tax Free Income Fund. Shareholders the two funds will vote on the proposed merger sometime in September. Should it be approved, all preferred and common shares will be redeemed.

Steven Baffico, head of closed-end fund sales at New York-based BlackRock Inc., said progress made in redemptions is tied to the demand for the new securities being created to replace ARPS and is being tested on a small level. Widespread usage and acceptance could take months.

“We’ve been working with money market investors to gauge demand (for new securities to replace ARPS), asking them, ‘Is it something you’d buy’,” said Mr. Baffico. BlackRock has redeemed $2.5 billion in ARPS of the $9.8 billion outstanding issued by the firm.Joseph Fichera, partner at Saber Partners LLC, a New York-based financial law firm, said the redemptions in the closed-end funds were important to restoring investor confidence in the market, but an overhaul of the auction process might prove the real cure for the marketplace.

“Neither issuers nor broker-dealers have changed the way auctions have been carried out and the only solutions seem to be either to redeem the securities with more fees and expenses and uncertain replacement costs or do nothing,” Mr. Fichera said.

“I think more can be done. The first prescription is to deal directly with investor confidence and make the auction process (in the future) fully transparent, along the lines of the Treasury market’s system.” A more transparent process would increase bidding competition and would boost market liquidity for ARPS.

“Nothing is wrong with an auction if it’s a true auction, not a managed bidding system,” he added.

Philip Maisano, Norwalk, Conn.-based chief investment strategist and vice chairman of Bank of New York Mellon Asset Management, which holds an undisclosed amount of ARPS, said the debate on how to redeem preferred shareholders continues.

“The question here is to whom do you (the fund manager) have the most obligation,” said Mr. Maisano. “You cannot sacrifice the common shareholders for the benefit of the preferreds. If there is an opportunity to redeem the preferreds without hurting the common shareholders and you could do it — deleveraging without hurting the common shares — then you should do it.”

Contact John D'Antona at [email protected]