Cecilia Gondar of Thomas J. Herzfeld Advisors did an incredible analysis of the risks of more stringent rating agency rules on how closed-end funds (mostly aiming at yield) use leverage to enhance their returns. Tom Herzfeld is the market guru for closed-end funds (CEFs) and she is his long-term researcher.
With Fitch already cracking down on these unstable tactics for improving CEF yields, now the even better-known Standard & Poors rating service plans a similar “stress test”. It has asked CEFs and other investment managers for comments preliminary to setting new rules
Dropping coverage from S&P (as they have from Fitch) will be harder for funds to get away with. Most want two ratings, from it and Moody’s which probably is planning to follow suit. S&P’s planned new rigorous tests are stricter than those which go back to the 1940 US laws on mutual funds are a result of the financial crisis, which saw some CEFs in violation of their covenants in 2008.
Cecilia writes:
“Unlike the ’40 Act asset coverage calculations, rating agencies don’t necessarily give a fund full credit for the market value of the underlying portfolio holdings. They routinely take ‘haircuts’ on portfolio market values when they make their asset coverage calculation and determine their rating.
“Haircutsare reductions in the value of a portfolio holding to account for risk factors such as market value fluctuations, amount of time to maturity, or having to sell into a distressed market. Riskier
asset classes tend to be subject to bigger haircuts.“Haircuts are expressed as a percentage of market value. A 50% haircut means only half of the position’s value is included when making the coverage calculation. A 100% haircut means none of the position’s value is used. A portfolio’s diversification is also taken into consideration.
“Above certain concentration levels, it is possible that a fund’s additional holdings may not be counted towards asset coverage at all.”
This is a double-edged whammy. If a CEF’s rating is cut from the triple-A which most yield funds aim for, its cost for leverage will go up, for example by sale of auction-rate preferreds or other debt. To deal with these rating agency haircuts, CEFs could reduce their leverage and invest in safer assets. But this will hurt their yields to investors, the big competitive selling point for funds.
What this means for our portfolio is discussed below. We also have news from the oil patch, our favorite ex-Commecon economy, and a gamble stock and two Canadian shares.
Note that my team of global stock pickers is currently checking out new portfolio ideas in Japan (yes, Japan), China, Britain, Ecuador, and (gasp) Ireland. The time to buy is when there is blood on the streets.
Three readers asked why I did not take off this year for the Jewish Succoth festival. I try not to be a hypocrite. Having moved my brokerage account from E-trade to Fidelity with effect today, I knew that I would have to work on that. If I work on an ACAT I have no reason not to write the blog. Moreover, neither of the children, who have back yards able to take a Succah for the holiday, invited us.
