(Dow Jones) A proposal by Standard & Poor's Ratings Services to tighten its ratings criteria for closed-end funds' preferred shares could result in downgrades and higher leverage costs for some funds.
That could pare the bottom line for some funds' common shareholders. Some advisors, like Maury Fertig, use closed-end funds as a way to generate value and income for clients.
The ratings agency has proposed changing how it analyzes the market value of certain investments when rating securities issued by leveraged closed-end funds regulated in the U.S., as well as some other investment vehicles. Among other things, it would establish minimum liquidation horizons for certain asset types, to address the risk that forced liquidation over short time periods can represent. It would also establish a scale of risk among asset types, according to its view of their relative liquidity and any tax advantages.
"The result could be widespread downgrades," said Cecilia Gondor, executive vice president at Thomas J. Herzfeld Advisors Inc. That, "in the current market environment, would result in higher leverage costs for funds using penalty rates to calculate dividends on their auction-rate preferred shares."
That added cost of leverage would in turn mean lower dividends for common shareholders, she said.
Many closed-end funds issued auction-rate preferred shares to boost returns for common shareholders, but they ran into trouble in February 2008 when the auctions at which the shares had been sold for years froze. Some funds have been delevering, while others have been slowly replacing preferred leverage with alternatives. Those that still have outstanding preferred shares are paying for the leverage according to preset formulas, generally linked to short-term financing rates. Those costs could rise if the funds are downgraded.
The proposed revisions would affect Standard & Poor's outstanding ratings on securities issued by 220 leveraged closed-end funds, it said. When the proposed revisions were applied to a sample of 90 AAA-rated securities issued by leveraged closed-end funds, only one could withstand its proposed AAA stress scenario, the service said.
Standard & Poor's is requesting comment on the proposal through the October 29.
Last year, when Fitch Ratings revised some of its criteria for ratings closed-end fund obligations, a few funds dropped the ratings agency rather than alter their portfolio holdings or accept a downgrade, Gondor said. Standard & Poor's proposed changes seem even more stringent than those made by Fitch, she said.
Henry Albulescu, managing director and criteria officer for structured finance ratings at Standard & Poor's, said it is possible that some funds will be downgraded or drop Standard & Poor's ratings. Ultimately, funds will have to make their own decisions, he said, and some may be driven by whether or not they feel they can operate without an S&P rating.