Last year, something happened in the closed end fund market that has never happened before. The Highland Floating Rate Opportunities Fund quietly made history by being the first mutual fund to convert to a closed-ended fund to protect its existing investors.
The reason why Highland decided to make the change goes back to 2015. In 2015 the fund won a $279 million judgment against an investment bank, which it claimed had caused a real estate appraiser to inflate the valuations of properties used to collateralized loans held by it. The fund subsequently won this judgment, but the investment bank appealed, which mean Highland had to book the award as a contingent asset. The development that forced the firm to make the change to a CEF was the prospect of potential dilution of its current shareholders by new investors speculating on the outcome of litigation.
Due to the timing of court judgments and subsequent payments, there could have been a significant lag between the two events, a lag that would have allowed speculators to make significant bets on the fund and then, it could have been forced to liquidate positions to meet a high volume of shareholder redemption requests. Under the new structure, speculators would only be able to invest in the Fund by purchasing shares from existing shareholders at a price determined by the market, rather than at net asset value.
According to credit rating agency Moody’s, in a report on the state of the CEF market, the Highland conversion helped increase the total value of gross IPO proceeds rose by 37% to $2.5 billion for the CEF universe in 2017. At the launch of the fund, it had assets of $1.1 billion, meaning that it accounted for just under half of the new issues last year. At year-end 2017, the aggregate holdings of US closed-end funds totaled $275 billion compared to $263 billion at year-end 2016.
The report also goes on to say that rising short-term rates are already having a significant impact on distribution levels of municipal CEFs:
“Rising short-term rates have eroded the interest coverage cushions for our universe of municipal CEFs. Funds have managed this pressure by decreasing their distribution rates. Approximately 60% of our rated CEFs decreased their distributions at least once during the year. The few funds (about 2%) that did increase distributions during the year, did so after making significant reductions in 2016 which when compared to their current distribution rates were much higher.”
