Money Matters: ARPS: One of the best investments ever

By George W. Karpus The Daily Record Newswire Most investments are backed by the full faith and credit, plant and equipment, or "good will" of a given issuer. You might be surprised to know, however, that you can you find an investment that, in many cases, is backed by nearly 300 percent of marketable collateral. The investments to which I am referring are auction rate preferred securities, or ARPS, issued by closed-end funds. ARPS are senior securities issued by closed-end funds with the purpose of providing enhanced yields to common shareholders through leverage. Overall, many of the remaining ARPS on closed-end funds are in closed-end municipal bond funds, which have a minimum asset coverage requirement of 200 percent. In many cases, the coverage ratio exceeds 300 percent. In other words, there must always be at least two times the amount of marketable bonds backing the ARPS issued by closed-end municipal bond funds. Further, should the value of the bonds drop below 2:1 coverage, the Investment Company Act of 1940 (Act of Congress) requires the fund to liquidate portfolio securities and redeem the preferreds at par. Thus, should a meltdown in the bond market occur, an investor in ARPS would have the potential of having their investment returned at par. I cannot imagine a scenerio where a class of bonds would lose one-third of their value and then lose another one-half of their value so quickly that these bonds could not be sold to redeem the required preferred shares. Essentially, this investment does not possess the risk of the underlying bonds that back the investment. To me, ARPS present an unparalleled opportunity on a risk-adjusted basis and indicate unparalleled safety! To provide a bit of a background on ARPS, in February 2008, the remarketing efforts of brokers that were conducting monthly (and sometimes weekly) auctions for these ARPS failed causing investors to be locked into this investment. As a key distinction, the auction process failed, not the securities. A secondary market soon developed in place of the auction process and savvy investors could buy these ARPS from the investors currently holding them. Starting in March 2008, we began buying these ARPS in the secondary market for our accounts. Our research indicated that many of the closed-end fund families would eventually redeem and/or refinance these ARPS at par value and that is what has happened. When we first began investing in ARPS, there were about $64 billion of outstanding preferreds issued by closed-end funds. Now, there are about $18 billion outstanding, meaning that roughly 72 percent have been refinanced or redeemed in the last three years. Additionally, one of the largest issuers recently came out with a press release indicating that they had priced a private offering of another type of security, the proceeds of which were announced to be used to redeem another $1.1 billion of ARPS. As a firm, I believe Karpus Investment Management has been one of the largest buyers of ARPS in the secondary market. The average price we have paid has been about 84 percent of par value. Most of our clients have experienced total returns of 10 percent (+/- 4 percent) on this investment. If we bought ARPS at 84 percent of face value and received about 1 percent in annual dividends, and it took two years on average to get refinanced out, we received in excess of a 10 percent annual return. If it takes four years to refinance, ARPS returns drop to about 5.5 percent annually. If it takes one year, returns can be 18 percent. Overall, returns have been fabulous for such a safe investment. Additionally, most ARPS pay dividends that are about 150 percent of a comparable short-term rate once their auctions fail. With rates so low over the last three years, we have averaged about a 1 percent current yield of our average purchase price. Should interest rates have risen, the 150 percent penalty rate of a benchmark would have been further magnified, which indicates that ARPS also provide a hedge against a rise in interest rates. In addition to terrific stand-alone performance, ARPS are a great portfolio diversifier because their returns do not correlate to the bond markets, stock markets or commodities. A well-diversified portfolio is constructed with assets that do not move in the same direction at the same time (i.e., assets are not highly correlated). Further, ARPS diversify bond portfolios because they are not sensitive to changes in interest rates. Should interest rates rise, dividends on ARPS would immediately rise. Consequently, we have purchased ARPS extensively in fixed income portfolios and modestly in equity portfolios. Currently, the opportunities to purchase ARPS in the secondary market has diminished. As stated previously, nearly 72 percent have already been refinanced and many of the holders that needed liquidity have already sold. In fact, our most recent purchase was completed at 92 percent of face value -- which we anticipate should be refinanced in about one year and produce about a 9 percent total return. Of course, all of the above returns are estimates and the returns indicated are by no means guaranteed or repeatable. Looking forward, as ARPS continue to be refinanced, I believe the next great opportunity is with the offspring of ARPS. In my opinion, this relatively new investment also provides features of safety with low duration and returns over 1 percent higher than comparable securities. These can be used to maintain above average returns while reducing duration in bond portfolios. This newer investment vehicle, however, is a topic which I will more fully explore in my next article. ---------- George W. Karpus is president of Karpus Investment Management, an independent, registered investment advisor that manages assets for individuals, corporations and trustees. Offices are located at 183 Sully's Trail, Pittsford, N.Y. 14534; phone (585) 586-4680. Published: Tue, May 17, 2011