The invention of Dutch-auction preferred stock spawned dozens of proprietary products from investment banks clamoring to get a piece of the $20 billion market. The failure of seven auctions since the product’s inception in 1984 sent only mild tremors through the market, but Dutch-auction preferred has backfired against issuers in shaky industries, which have by and large been forced either to redeem or to pay astronomical rates. The most notorious recent example: last November’s rate spike on Citicorp’s $925 million of Dutch-auction preferred, which forced the bank to pay a bonus of up to 650 basis points and redeem three other issues.
Enter Bear, Stearns & Co., which last year provided two missing ingredients — flexibility and innovation — to restore investor confidence in the troubled outstanding Dutch-auction-preferred-stock issues of the Prospect Street High Income Fund and the New America High Income Fund. Neither the issues’ triple-A ratings nor Financial Security Assurance guarantees could protect them when the original sole manager on both issues, Drexel Bumham Lambert, filed for Chapter I I in February. New America’s $39 million, 30-day auctions failed repeatedly at 130 percent of prevailing commercial-paper rates, while Prospect Street’s rate on its $30 million outstanding shot up from an average dividend rate of 106 percent of commercial paper before Drexel dropped out to a rate of 162 percent afterward.
According to Joseph Fichera, the Bear Steams associate director who led the restructuring effort, “The credit and the structures of these issues were solid. It would just take a coordinated team effort to get the auctions back on track.” To that end, Bear Steams negotiated additional covenants for the Prospect fund to maintain its tripleA rating. The firm also structured in a clause to protect investors, which requires the fund to redeem the preferred at its issue price if the auction fails before the expiration of its FSA surety bond in December 1993. To bring investors back to New America’s preferred, Bear Stearns and FSA created a special-purpose company, independent from the junk bond fund, that will buy any preferred unsold in each auction at a rate below the fail rate. Bottom line: Bear Stearns brought the average rate on New America’s preferred down to 8.3 percent, or 103 percent of commercial paper, and Prospect Street’s back down to 8.5 percent, or 107 percent of commercial paper.
“Investors saw the value in the changes to the preferred, and that’s been reflected in the funds’ low dividend rates,” says John Koren, Bear Steams managing director and head of corporate coverage in sales. Says Russell Brewer, a managing director at the FSA involved in the restructuring of New America’s preferred, “Some of the thinking behind this restructuring could be applied to other issuers, such as [the $3.4 billion] mutual-fund auction preferred market.”