Closed End Funds Scurry To Keep Within Leverage Rules
By: Tim McPartland,
We have written frequently about the leverage rules that closed end funds (which includes Business Development Companies) must follow per the SEC Act of 1940, Section 18 and at this point in time the rules are starting to bite in the CEF world. In general debt of CEFs must have a asset coverage ratio of 300% on debt and 200% on preferred stock and anytime they get remotely close to these limits management gets really nervous–and for good reason. CEFs are not allowed to pay distributions if they are in violation of Section 18. They must be certain of meeting the leverage rules at the time of the dividend declaration.
The above tends to get the attention of management really quick and they begin to act in plenty of time to make sure that no violation occurs–in fact they tend to go somewhat overboard.
So how do they deal with a potential pending violation? 1st off they can sell assets–i.e. shares in the companies the CEF owns and use the proceeds to pay down debt or redeem preferred stock. Let’s look at the math here.
Coverage ratio is 400%
Now let’s assume that this Sample CEF is a MLP focused fund and the numbers now look like this–
Assets $ 60
Debt $ 25
Coverage ratio is 240%
So you can see that our Sample CEF now is NOT ALLOWED to declare dividends. Currently this is very close to a real world example and the selling of assets by CEFs has served to drive unit prices of MLPs down bunches–as we have seen. This is a situation where they have to sell to pay debt to maintain coverage ratios and the selling drives prices lower making the matter even worse.
Assume further that our Sample CEF sells $10 in assets and uses the $10 to pay down debt. Now coverage looks like this–
Assets $ 50
Debt $ 15
Coverage ratio is 333%
Now the Sample CEF is allowed to declare dividends.
A 2nd option is that the CEF can sell preferred shares and use the proceeds to pay down debt. This works because the coverage requirements on preferred shares is just 200% and the proceeds can be used to pay down debt which needs a coverage ratio of 300%. In the example above if the leverage was preferred stock instead of debt our Sample CEF would not have been in violation of Section 18.
Let’s look at a real life example. We will use Tortoise Energy Infrastructure Corp (ticker:TYG) as our example. TYG preferreds have been our favorite for years–primarily because they are rated ‘AA’ by Fitch. Even though their preferreds have been our favorites the common units have been hammered hard. 1 year ago common units were around $48/share–now they are $28. 1 year ago the asset coverage ratio on debt was 472% and on debt and preferred combined was 400%. Today the ratios are 361% and 248% for preferred shares.
Needless to say Tortoise is concerned with coverage ratios and released a statement today–a portion of which is as follows–
“Especially in this volatile market environment, we will continue to closely monitor asset coverage ratios and take steps, as prudent, to maintain adequate cushion over coverage requirements” said Managing Director, and closed-end fund CEO, Brad Adams. “The conservative nature in which we manage our funds allows us to take a measured, low-impact approach. We maintain our conviction for the MLP sector in which we invest, and believe that the fundamentals remain strong.”
While this type of activity is most pronounced in the MLP CEF’s it will be apparent in many sectors of CEF’s if we have a prolonged downturn in stock prices as virtually all CEFs are leveraged.
Thus far we have observed some CEFs in the MLP sector doing private placements of term preferred stocks to pay down debt and a limited amount of new issuance of common shares which bolsters coverage ratios, but the bigger affect so far has been in the downward pressure caused by asset sales to pay down debt.
Lastly we must remember that BDCs are CEF’s and are required to follow Section 18 leverage rules. The difference with BDC’s is that you have to generally ‘trust’ management to value their assets correctly. Remember that most assets owned by BDC’s are not shares of publicly traded companies, but instead are private companies and solid values are ‘not observable’. This always concerns me, but is good reason to make sure you review your holdings every couple of months.
We will keep our eyes on the leverage situation, but each investor needs to be aware and monitor their CEF holdings as we are unable to monitor all the funds out there.