A Sure Thing That Wasn't

Pimco, the nation's best-known bond manager, prides itself on going its own way. This independence has let Pimco take victory laps lately for huge wins, like buying Fannie Mae and Freddie Mac bonds when others shunned them -- and holding on to a ton of GMAC paper while other owners traded theirs in at a huge discount. But you won't hear Pimco discussing what happened when it went its own way -- and stumbled -- in a tiny corner of its $800 billion operation: leveraged closed-end municipal bond funds.

In December, the firm found itself forced to postpone dividends on eight of its funds because it had been too clever by half. The funds are perhaps one-200th of Pimco's assets, the postponed dividends about $13 million. Chicken feed by Pimco's standards. But it's a big embarrassment because Pimco became the first manager in modern times (or maybe ever) to defer dividends on these funds, which have 12 annual payouts and are sold as reliable monthly income generators.

"It's the first time I've ever seen a dividend postponed on one of these funds," said Cecilia Gondor, executive vice president of Thomas J. Herzfeld Advisors, who has followed closed-ends for 25 years.

Pimco's competitors in this small but lucrative niche (240 funds with about $65 billion in assets, according to Herzfeld Advisors) didn't have to suspend their dividends. That's because these firms -- Nuveen, BlackRock, Eaton Vance and Van Kampen -- managed their funds more conservatively. They also got lucky.

Pimco says it doesn't want to discuss the fiasco, which has gone largely unnoticed outside the fund world. But pore through enough documents and talk to enough people (most of whom declined to be quoted), and you can see what happened.

Before we proceed, a brief primer. With regular, open-end funds, investors buy shares from the fund and sell them back when they leave. Closed-end funds, by contrast, sell a fixed number of shares (usually through retail brokers), which then trade on stock exchanges. This means that managers don't have to worry about assets leaving, as they do with open-end funds. Thus, closed-end bond funds feel safe borrowing money (in this case, about 50 cents for each dollar of common stock sold), which they use to buy more bonds. Ideally, common holders profit because the extra bonds produce more income than the interest costs on the borrowed money, while managers profit by having more assets on which to collect fees.

Enter the snake into this Eden. The Pimco funds used auction-rate preferred stock to borrow money. As you may know by now, owners of such preferreds are supposed to be able to sell them at face value every seven or 28 days at periodic auctions -- but last year auctions began to fail. Screaming started as preferred holders found that they couldn't get their money out.

Pimco's competitors sold "tender option bonds" to raise money to pay off some or all of their preferred. Pimco decided that leaving the preferred in place was a better deal for common holders because the preferred carried lower borrowing costs, and tender option bonds, unlike the preferred, can be cashed in on short notice.

Now the cruncher. Under U.S. securities laws, a leveraged fund using preferred stock can't pay dividends to common holders if its net assets are less than double its borrowings.

As muni bond prices plummeted late last year, Pimco's funds, whose assets were originally about three times borrowings, breached the 2-to-1 threshold. Pimco's competitors had no such problems because tender option bonds are technically derivatives, the word "bonds" notwithstanding. Thus, they don't count as borrowings.

Merrill Lynch closed-end-fund analyst Jon Maier said that in addition to the no-tender-option-bond strategy, something else distinguished Pimco's funds: heavy bets on Treasury bond prices falling. Instead, Treasury prices rose as muni bond values plummeted, a double whammy eroding the Pimco funds' asset values. The dividend postponements followed.

Pimco has restored the dividends by having its funds sell bonds to raise money to pay down its auction preferred. The funds took hits on these sales -- how big, I can't tell. The bottom line: Even when you're invested with a superstar firm like Pimco, there's no such thing as a sure thing. Even smart contrarians can't win them all.

Allan Sloan is Fortune magazine's senior editor at large. His e-mail address is asloan@fortunemail.com.