Thanks Bill.

Looks like more mumbo jumbo that we, the CEF shareholders, will have to sift through and analyze. It always seems to get more complicated rather than simplified.

How is this going to cost less than just borrowing the money from a financial institution?

Ahhh, but these TOBs will still be considered part of the fund total assets (as were the APS), and therefore will be included in the management fee. Now it all becomes clear again!

"TOBs are derivative securities created by placing high quality municipal bonds into a trust arrangement and, in exchange, each respective Fund receives cash and a residual interest security (sometimes referred to as an “inverse floater”) issued by the trust. The trust then issues securities (sometimes referred to as “floaters”) which are purchased by third parties and which pay interest rates that reset weekly based on a short-term index rate. These floater securities, once purchased, can be tendered back by the holder to a liquidity provider at par. The Funds would continue to earn the interest from the bonds that comprise the trust, less the interest paid to the holders of the floaters and any fees associated with the transaction. Additionally, the Funds would use the cash received from the municipal bonds placed in the trust and from the issuance of the floaters for investment purposes.

The successful implementation and use of TOBs depends on a number of factors, including the availability of high quality municipal bonds at certain yield levels to be transferred to the trust structure, the ability to secure liquidity providers for the put feature, and the general market demand for the floaters issued by the trust. TOBs are subject to leverage risk and interest rate risk. A rise in short-term interest rates would result in an increase in the interest payable on the floaters but a decrease in the income generated by the inverse floaters, thereby resulting in a decline in the income to the common shareholders, and possibly a decline in the overall yield and market value of each respective Fund’s common shares."

Best,

Steve 

Hi Bill and Steve-

When you look at all the permutations and combinations of what might happen as Van Kampen and others address leverage problems, if I had to bet, I would bet that the leveraged CEF munis will not be as attractive in the next five years and they were in the past five years. How would you bet?

 As you know, a ton of these funds on a total return basis had an average total return over the past five years of more than 6%. The vast majority of these were single state funds. APX  which Steve mentioned some time back averaged 10% in this same period.

Ed

Imho, CEF management's responsibility is to fund leverage at the lowest available cost to common shareholders, taking into account stability of the vehicle used.  For a long time that has marginally been ARPs, even though money market funds and many others were denied access to their AAA rated portfolio collateral because of the ARPs' long maturities.

The lending institutions providing liquidity to the  ARPs auction market have temporarily withdrawn because of the way reserve capital is counted, but there is still a vast and growing demand for money market rates, which currently vary from 1.82% on 30 day Tbills to an average of 3.37% on bank FDIC MM accounts.

By adjusting the CEF leverage market to other venues in which more participants are able to play, such as via VRDS, TOBS, senior bank loans and reverse repos, even muni CEF should be able to find sources of short term money lower than the longer term muni bonds in which they invest and even lower than the  ARPs default rates currently in effect. To a bank, loaning money with highly rated collateral at a profitable rate can look better than investing it at the same number.

When short  rates rise, so should muni CEF portfolio interest. While that impacts CEF NAV and investor interest in the asset class,  it may not be a deterrent to the use of leverage. 

I share the current concern over the instability in leverage costs, but  believe the underlying market for cash equivalents is still alive and well and that CEFs will find a way to get to it at the lowest cost.  Count me as optimistic, if not euphoric.
 

Bill-

 As usual, I appreciate your thoughtful comments which put things in perspective.

Ed

Count me as optimistic, if not euphoric.

Wow Bill! If you're euphoric, then so I am. You usually use superlatives rather sparingly so This one had me stand up and take notice.

I just hope that the CEF managers will actually recognize their fiduciary responsibilities to the common stockholders, and ease up on lining their own pockets at the shareholders expense.

Best,

Steve 

I'm glad that we got that cleared up. Bill is usually very careful about avoiding an out right buy recommendation, so the euphoria comment made me sit up and dwell upon the deeper meaning of it all. Anyway, "optimistic" may not be as exciting as "euphoria" but the world does seem to be set right again.

 David
 

Here's a "fair use" excerpt from today's Barrons, a lengthy article on the probable outcomes for various auction rate securities.  I've extracted a portion on Muni CEF leverage, which explains why the workout is both complex and lengthy.

Municipal Closed-End Funds

These funds, which own municipal bonds, face all the above problems with an added twist. Dividends on auction-rate preferred securities of municipal closed-end funds are tax deductible. If the same funds sold debt, the interest payments wouldn't be deductible, and their interest rates would have to be higher.

So fund families that sold closed-end muni-bond funds have been scrambling to create a new preferred security. At Nuveen it's called Variable Rate Demand Preferred. At Eaton Vance, it's Liquidity Protected Preferred stock.

The securities vary but generally involve a frequent auction to set the dividend rate. If the auction fails, existing holders would have an option to put the security back to a bank that would agree to hold it for a preset term. On some securities the preferred dividend rate would rise so high the fund family would be forced to repurchase them from the bank.

Some funds have asked the SEC to allow money-market funds to purchase the security because it has a put option. If so, that would bring a huge new buyer to the market and the added liquidity might get the auctions working again. "We expect to be able to respond affirmatively fairly quickly in the next couple of weeks," says Robert Plaze, associate director, division of investment management at the SEC.

That said, the security faces tax questions. Will Treasury deem it preferred stock or debt, given the fund will ultimately buy it back? And again, banks must go along.

Municipal closed-end funds have about $28 billion of auction-rate preferred stock outstanding."