PIMCO has frozen dividends yesterday on six municipal bond funds because the value of their investments is insufficient to cover the funds' debt.

The six funds—Pimco Municipal Income Funds II and III, Pimco New York Municipal Income Funds I and III, and Pimco California Municipal Income Funds II and III—will not declare a dividend for December or pay the dividend declared for November, which was payable last Monday.

The funds, launched between June 2001 and October 2002, invest mainly in high-quality municipal debt and use interest payments from the bonds to issue monthly dividends to shareholders.

The funds supplemented the capital raised from selling common shares at their inception by selling a type of preferred stock known as auction-rate preferred shares.

PIMCO, which sold the so-called ARPS for $25,000 each, pays an interest rate on these securities that is reset at an auction every seven days. This closed-end fund design is intended to enhance the dividends paid to common shareholders by leveraging the investments with money borrowed through ARPS.

Under the Investment Company Act of 1940, a closed-end fund's assets must equal at least double the liquidation value of the preferred shares. Otherwise, the fund is not permitted to pay dividends.

"Continued severe market dislocations" and "further erosions in the municipal bond market" have rocked the value of the funds' bonds, PIMCO said. The muni market has suffered through much of 2008 as investors have parked their money in safe havens like cash and Treasury bonds.

The six funds' asset values have as a result slipped below the required 200% coverage ratio, PIMCO said.

For example, double the liquidation value of the preferred shares of the New York Municipal Income Fund III is $94 million. The fund reported net assets of $104.4 million at the end of October. That implies the value of the fund's assets has slipped roughly 10% in a month. PIMCO’s New York Municipal Income Fund I's asset value has tumbled from $137.5 million to at most $126 million, implying an 8.4% decline in a month.

The two funds invest in bonds issued by government bodies in New York. Faced with slowing tax revenue, the state is struggling to close a $1.5 billion budget deficit this year.

Some of PIMCO's funds that invest in municipal debt in California are under stress, too. The California Municipal Income Fund II's assets have dropped from $547 million at the end of October to at most $520 million, implying a decline of at least 5%. California Municipal Income Fund III, with assets at nearly $400 million at the end of October, has dipped at least 7.1%.

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