ARPS - An investment with low risk and high return

By Kevin B. Murray The Daily Record Newswire Ordinarily risk and return go together. Those seeking higher returns on their investments, usually must take on additional risk as the cost of (hopefully) receiving them. Similarly, as we were all told as youths, when something seems too good to be true -- there is often a catch somewhere. From time to time, however, situations arise where astute investment managers are able to find opportunities that provide high return with low risk. Such an investment opportunity became available in 2008 with Auction Rate Preferred Securities. ARPS are senior securities issued by closed-end funds, in denominations typically of $25,000, that were used by institutional and high net worth investors as a money market alternative. The interest rate on ARPS was reset regularly through an auction every seven, 28 or 35 days. Buyers were attracted because they received a slightly higher interest rate and had an apparent assurance of liquidity through the auction process. All went well until February 2008. Then, because of the credit crunch, the auction process that had worked smoothly since the 1980s failed. At that time, the major brokerage houses that would purchase any unsubscribed ARPS and sell them to their clients had liquidity problems of their own and stayed out of the market. Thus, while the underlying securities were still safe and continued to pay interest, the auction failed, and the owners lost their liquidity. What some lost sight of is that despite the auctions failing (imbalance of buyers and sellers) the underlying securities were still of the highest safety. To provide the now lost liquidity, a secondary market soon developed. ARPS owners, who needed liquidity, sold them to those without a pressing need for liquidity at deep discounts to their par value. This provided, as George Karpus indicated in his December 2008 article in The Daily Record, "a once in a lifetime investment opportunity." First let us look at why ARPS are low risk investments. As a senior security, ARPS are required to have a minimum coverage ratio of 200 percent. That is, there must be at least two times the amount of marketable bonds backing the ARPS. The Investment Act of 1940 provides a safeguard to ARPS holders that if asset coverage falls below the 200 percent coverage requirement, the closed-end funds would have to redeem a portion of the ARPS at par to correct the shortfall. The senior status of ARPS also requires all dividends be paid on ARPS before any are paid to common shareholders. With these statuary safeguards, as well as asset coverage, ARPS are one of the safest securities an investor can buy. Now let us look at how ARPS have performed. Karpus Investment Management has purchased, for our clients, ARPS with a par value of over $980 million for $825 million. That is, when redeemed, these ARPS will give an 18.8 percent capital gain in addition to the interest they pay. As of Dec 31, 2011, over $582 million of these ARPS have been redeemed and another $80 million is scheduled for redemption in January 2012. By the end of this month three quarters of all ARPS purchased will have been redeemed at par. Given that the average holding period for those ARPS redeemed has been 13 months, the average capital gain to ARPS holders was an annualized 17.4 percent. In addition the ARPS holders received a small interest rate during the time they held the security. Many of the closed-end funds that issued ARPS have publicly indicated their intent and timetable for redeeming their outstanding ARPS at par in the near future. In summary, ARPS are extremely safe securities, which, at a time when a one-year Treasury is paying .134 percent, gave you an annualized total return of close to 18 percent. Karpus Investment Management has included ARPS as a part of most every account over the past three years, and they contributed to both the safety of these accounts and to their performance. While in general there is no free lunch, ARPS have proven to be a very low risk way to enhance your investment returns. The New Year tends to be a time to predict what will happen in the future. We should also look back to see if those who made predictions in the past were accurate or not. Those whose past predictions have proven to be accurate, should be listened to a little closer than those who were wrong in the past. ---------- Kevin B. Murray is a vice president at Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees. Offices are located at 183 Sully's Trail, Pittsford, N.Y. 14534; phone (585) 586-4680. Published: Thu, Jan 19, 2012