Fitch: Taxable CEFs Rely on Select Few Banks for Funding

NEW YORK--(BUSINESS WIRE)--Banks continue to actively lend to taxable closed-end funds (CEFs), helping CEFs meet their demand for short-term leverage, according to data compiled by Fitch Ratings. Approximately 174 taxable CEFs utilized an aggregate of $24.4 billion in bank borrowings as of 1H12. That amount was up $2.8 billion, or 13% year over the year, and now constitutes 68% of total on-balance sheet leverage in the sector.

“sticky. In addition, the due diligence process, operational setup and legal documentation can also be time-consuming to set up and execute. A small discount in cost from a competing bank would not necessarily entice the fund directors to go through the entire process again with a new counterparty.”

The aggregate lending remains concentrated among a short list of banks. At least 45% of all committed bank line and margin loan leverage is provided by one bank, and 65% by the top five. We believe these numbers are closer to 75% and 85%, respectively, when extrapolating financial data that did not disclose lender identity.

From a lending perspective, CEFs are viewed as relatively safe, having emerged from the financial crisis without any defaults on debt. That has generated interest from banks with a smaller market footprint and has also allowed new entrants to increase their presence in this sector. Generally the cost of bank borrowings for CEFs continued to fall during 2012, which could be due in part to an increasing desire by banks to lend in this sector. For example, committed credit lines and margin loan products became cheaper by 25 to 35 basis points over time (as a spread over Libor).

While growth prospects are attractive, we note there can be significant barriers to entry for banks seeking to extend lending to funds in this sector. Relationships between current lenders and fund managers/fund board of directors are often "sticky. In addition, the due diligence process, operational setup and legal documentation can also be time-consuming to set up and execute. A small discount in cost from a competing bank would not necessarily entice the fund directors to go through the entire process again with a new counterparty.

There has also traditionally been a lack of dedicated lending groups within most financial institutions that cater to 1940 Act funds. Lending to the sector has historically come from different parts of a bank, i.e. prime brokerage for reverse repurchase agreements and the corporate group for direct lending. Dominant lenders today are successful in gathering the right resources and capital in order to provide different product offerings.

Lastly, fund board of directors expects a certain level of expertise from the bank and a track record to demonstrate commitment. Fund management must be able to trust that the counterparty would not unexpectedly pull the line or be involuntarily forced to do so due to capital constraints in a time of stress.

See Fitch's full review and outlook for the closed-end fund sector in its recently published report "2013 Outlook: Closed-End Funds" (Dec. 14, 2012), available on www.fitchratings.com.

Additional information is available on www.fitchratings.com.

The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article, which may include hyperlinks to companies and current ratings, can be accessed at www.fitchratings.com. All opinions expressed are those of Fitch Ratings.

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