Auction-Rate Preferred Shares are short term securities associated with an
underlying exchange-traded closed-end fund, and are offered to investors in
conjunction with a closed end fund leveraging its assets. These funds are in no
way guaranteed by any agency of the US Government.
The purpose to the investor is to provide higher short term interest rates
than would be available in the typical money market fund.
While the market for these shares are generally liquid, liquidity is not
promised.
The proceeds received from these preferred shares are invested in the closed
end fund’s “long term” portfolio – in other words, its main investment strategy.
The funds received are used to buy a leveraged portfolio of these securities.
Preferred shareholders receive a regular dividend based on short-term
interest rates. Rates are set by an auction process, and are typically, but not
always, reset weekly.
As long as the short-term interest rates paid to the preferred shareholders
are lower than the net long-term rates earned by the underlying fund's
portfolio, the fund’s common shareholders will earn higher rates that they would
have without a preferred share class (without leverage).
If the short-term rates paid to the preferred shareholders approach the
return earned by the fund’s portfolio, the beneficial effects of leverage are
reduced and the additional amount available to distribute to common shareholders
declines. However, as with a regular operating company such as IBM or General
Motors, dividends due to preferred shareholders must be paid before any
dividends are paid to common shareholders.
Auction-Rate Preferred Shares provide liquidity through the auction process,
which is typically weekly, not daily. As short-term interest rates rise (as
measured by the Fed Funds’ overnight lending rate), the rates demanded by
preferred shareholders also typically rise. Conversely, as short-term interest
rates fall, the rates set by the auction process also generally fall.
In addition, as short-term rates rise, leveraged funds may experience greater
volatility than unleveraged funds. This means the underlying closed end fund
portfolio experiences greater variations in its net asset value and common share
market price, which can affect the perceived investment risk and credit ratings
of the preferred shares as well.
Closed-End ETFs typically have a leverage ratio between 33% to 50% of assets.
For example, a Closed-End ETF with $100 million in assets may borrow $50
million, for a ratio of $50/($100+$50) or 33%. Typically, only Closed-End ETFs
that leverage through the issuance of preferred stock have leverage ratios
approaching 50%.
Preferred shares of exchange-traded closed-end funds fall into just as many
categories as the underlying closed-end funds. In all cases, preferred shares
seek to provide yields that compare favorably with short-term instruments in the
same, or similar, asset class as the underlying funds. Preferred shares of
municipal bond closed-end funds seek yields that compare favorably with other
tax-free short-term instruments, or that compare favorably on an after-tax basis
with any taxable short-term instruments.
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