Fitch Affirms Preferred Shares of Western Municipal Closed End Funds
Fitch affirms the following:
Western Asset Intermediate Muni Fund Inc. (NYSE: SBI)
--\\$47,400,000 of VRDP Shares series 1, final mandatory redemption on Feb. 25, 2045 at 'AAA/F1'. The liquidity provider is Citibank, N.A. (rated 'A/F1');
--\\$2,600,000 of series M perpetual ARPS, at 'AAA';
Western Asset Managed Municipals Fund Inc. (NYSE: MMU)
--\\$3,225,000 of series M perpetual ARPS, at 'AAA';
--\\$7,075,000 of series T perpetual ARPS, at 'AAA';
--\\$6,900,000 of series W perpetual ARPS, at 'AAA';
--\\$13,350,000 of series Th perpetual ARPS, at 'AAA';
--\\$1,525,000 of series F perpetual ARPS, at 'AAA'; and
--\\$217,575,000 of VRDP Shares series 1, final mandatory redemption on March 4, 2045 at 'AAA/F1'. The liquidity provider is Citibank, N.A. (rated 'A/F1').
Western Asset Municipal Partners Fund Inc. (NYSE:MNP)
--\\$66,500,000 of VRDP Shares series 1, final mandatory redemption on March 11, 2045 at 'AAA/F1'. The liquidity provider is Citibank, N.A. ('A/F1').
KEY RATING DRIVERS
The short-term rating of the VRDP Shares primarily reflect:
--The credit strength of Citibank, N.A. ('A/F1') as liquidity provider;
--The terms and conditions of the purchase agreements.
The 'AAA' long-term rating primarily reflects:
--Sufficient pro-form asset coverage provided to the VRDP Shares;
--The structural protections afforded by mandatory de-leveraging provisions in the event of asset coverage declines;
--The legal and regulatory parameters that govern the fund's operations;
--Both the short- and long-term ratings also reflect the capabilities of Western Asset as investment sub-adviser.
FUND PROFILE
The funds are registered as a diversified, closed end management investment company under the 1940 Act and invest mainly in investment grade municipal securities.
SBI's investment objective is to provide common shareholders a high level of current income exempt from regular federal income taxes consistent with prudent investing. MMU seeks to maximize current income exempt from federal income tax as is consistent with preservation of principal. MNP's primary investment objective is to seek a high level of current income which is exempt from regular federal income taxes, consistent with the preservation of capital.
FUND'S LEVERAGE
As of Dec. 31, 2015, SBI had approximately \\$198.2 million in assets. Total leverage consisted of \\$2.6 million of ARPS and \\$47.4 million of new VRDP Shares.
As of Dec. 31, 2015, MMU had approximately \\$865.8 million in assets. Total leverage consisted of \\$32.1 million of ARPS and \\$217.6 million of VRDP Shares.
As of Dec. 31, 2015, MNP had approximately \\$251.7 million in assets. Total leverage consisted of \\$66.5 million of Fitch-rated VRDP Shares and \\$18.5 million of ARPS.
Within each fund's capital structure, the VRDP Shares rank on parity with the ARPS, as to the payment of dividends and the distribution of assets upon liquidation.
ASSET COVERAGE
The funds' asset coverage ratio, as calculated in accordance with the Fitch total and net overcollateralization tests (Fitch OC tests) per the 'AAA' rating guidelines outlined in Fitch's closed-end fund criteria, were in excess of 100%. These are the minimum asset coverage guidelines required by the fund's governing documents.
The Fitch OC tests calculate standardized asset coverage by applying haircuts to portfolio holdings based on riskiness and diversification of the assets and measuring their ability to cover both on- and off-balance sheet liabilities at the stress level that corresponds to the assigned rating.
As of Dec. 31, 2015, the effective leverage ratios were 26%, 29% and 34% for SBI, MMU and MNP respectively. These levels are below the 45% maximum allowed by the governing documents of the VRDP Shares.
As of Dec. 31, 2015, the funds' asset coverage ratio for total leverage, as calculated in accordance with the Investment Company Act of 1940, also at current market values, was in excess of 225%. These are the minimum asset coverage ratios required by the fund's governing documents.
ARPS STRUCTURAL PROTECTIONS
Should the asset coverage tests decline below their minimum threshold amounts (as tested on the last business day of each month), the governing documents require the fund to alter the composition of its portfolio toward assets with lower discount factors (for Fitch OC tests), or to reduce leverage in a sufficient amount (for both the Fitch OC tests and the 1940 Act test) to restore compliance within a pre-specified period (a maximum of 58 business days for the Fitch OC tests and a longer period for the 1940 Act tests).
VRDP STRUCTURAL PROTECTIONS
For the VRDP Shares, a breach of the effective leverage ratio is a breach of the fee agreement with the liquidity provider, and, at the option of the liquidity provider, may result in mandatory tender of VRDP Shares for remarketing (see VRDP Purchase Obligation section below for additional details). However, in the event of a breach, Fitch expects the funds to redeem sufficient VRDP Shares to restore compliance. The effective leverage ratio is tested daily.
For the asset coverage and effective leverage ratio tests, the total market value exposure periods (i.e. the pre-specified time period allotted for valuation, cure and redemption in the event of a breach) are within the 60 business day guidelines provided in Fitch's criteria.
VRDP PURCHASE OBLIGATION
The short-term rating assigned to each series of VRDP Shares is directly linked to the short-term creditworthiness of the liquidity provider. The VRDP Shares of each series are supported by a purchase agreement to ensure full and timely repayment of all tendered VRDP Shares plus any accumulated and unpaid dividends. The purchase agreement is unconditional and irrevocable.
The VRDP purchase agreement requires the liquidity provider to purchase all VRDP Shares tendered for sale that were not successfully remarketed. The liquidity provider must also purchase all outstanding VRDP Shares if the funds have not obtained an alternate purchase agreement prior to the termination of the purchase agreement being replaced or following the downgrade of the liquidity provider's rating below 'F2' (or equivalent).
The role of the liquidity provider under the fee agreement relating to the purchase obligation has a scheduled termination date. Subsequent to the scheduled termination date, the fee agreement can be extended with the existing liquidity provider, or a new liquidity provider may be selected. Any future changes to the terms of the fee agreements or any prospective replacement that weakens the structural protections discussed above may have negative rating implications.
STRESS TESTS
Fitch performed various stress tests on the funds to assess the strength of the structural protections available to the preferred shares compared to the stresses outlined in Fitch's closed-end fund rating criteria. These tests included determining various 'worst case' scenarios where the fund's leverage and portfolio composition migrated to the outer limits of its operating and investment guidelines.
Only under remote circumstances, such as increasing the funds' issuer concentration, while simultaneously migrating the portfolios to a mix of 80% long-term 'BBB' 10+ years to maturity bonds and 20% high yield bonds, did the asset coverage available to the VRDP and VRDP shares fall below the 'AAA' threshold, and instead passed at a 'AA' rating level.
Given the highly unlikely nature of the stress scenarios, and the minimal rating impact, Fitch views the funds' permitted investments, municipal issuer diversification framework and mandatory deleveraging mechanisms as consistent with an 'AAA' rating.
THE ADVISOR
Western Asset acts as the sub-adviser to the funds, providing day-to-day management of each fund's portfolio. Legg Mason Partners Fund Advisor, LLC acts as the investment manager to the funds, providing management and administrative services. Western Asset is a wholly owned subsidiary of Legg Mason, Inc. As of Dec. 31, 2015, Western Asset had approximately \\$433 billion in assets under management (AUM).
RATING SENSITIVITIES
The ratings assigned to the VRDP Shares and the ARPS may be sensitive to material changes in the leverage composition, portfolio credit quality or market risk of the funds, as described above. A material adverse deviation from Fitch guidelines for any key rating driver could cause ratings to be lowered by Fitch.
Certain terms relevant to key structural protections of the VRDP shares, including the minimum asset coverage and the effective leverage ratio are set forth in the fee agreements relating to the purchase agreements and are renewed on a periodic basis. Any future changes to these terms that weaken the structural protections may have negative rating implications.
The short-term ratings assigned to the VRDP shares may also be sensitive to changes in the financial condition of the liquidity provider. A downgrade of the liquidity provider to 'F2' would result in a downgrade of the short-term ratings of the VRDP shares 'F2,' absent other mitigants. A downgrade below 'F2', on the other hand, would not necessarily result in a downgrade of the short-term rating of the VRDP shares, given the features in the transactions that would result in a mandatory tender of the VRDP shares for remarketing, or purchase by the liquidity provider in the event of a failed remarketing.
The funds have the ability to assume economic leverage through derivative transactions which may not be captured by the minimum asset coverage test or effective leverage ratio. The funds do not currently engage in derivative activity and does not envision engaging in material amounts of such activity in the future. In fact, such activity is limited by the investment guidelines of the funds and could run counter to their investment objectives of achieving tax-exempt income. Material derivative exposures in the future could have potential negative rating implications if it adversely affects asset coverage available to rated preferred shares.
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