Auction Rate Bond Market feels the pinch

US bond market on a freezeThere has been unforseen intervention by the US Fed in the American markets, however there is still a domino effect, today we saw that there was a problem with the Auction Rate Bond Market and it has culminated in an investigation by nine state regulators.

It was said in the past that the Auction Rate market was dead after Wall Street banks ceased to purchase their own unwanted bonds, Auction Rate Securities are not liquid and this has resulted in the above case which broke in the news today. Investors were lead to believe that the bonds were a ‘cash equivalent’ however they are not, and the regulator is pushing to over rule the bonds because if money was to be seen as cash going in it has to be treated as cash on the way out (i.e.: it can’t be tied into conditions).

Auction Rate Bonds allow issuers such as Governments, Hospitals and Municipalities to issue debts that mature in up to 40 years at short term rates that can change every 7, 28, or 35 days through bidding. This market faced blow after blow in 2008 as many investors ran from them fearing the debtors would not be able to meet their obligations. Dealers used to step in to mop up any un-purchased bonds but from 2008 they started to shy away as Investment banks wrote down $245 billion and this caused an almost instant hit in the Auction Rate Bond market. Some investors were left with bonds they could not turn into cash and some issuers were left paying penalties of up to 20%. “The usual liquidity providers could not provide liquidity” according to CitiGroup, it was more fuel to the credit mess.

In mid-march 67% of auctions failed, not unlike the trend we are seeing in Irish Property auctions. I should explain what an Auction rate is though, if you are a Government and you need to raise money you can create a Bond, National Treasury Management Agency (NTMA) which run Ireland’s national wealth issued a bond at the end of last month for €7 billion that was oversubscribed, it was the largest syndicated transaction in the Euro area in over four years in the Government Bond market, so basically the Government borrow from Joe Public investors or Institutional Investors and then they pay a certain margin and ultimately all of the money at the end of the term, in this case the bond matures in 2019.

bond market graphSo if you are ever bored enough to follow the ‘Municipal Bond Market’ then what you are hearing discussed is basically local governments (municipalities) and School Districts, and the Bonds that they put out to raise money, this money which comes from investors is then used for various projects, typically things requiring capital spending for which they don’t have the money at hand, and a certain amount of interest is paid. Sometimes this interest is exempt from tax and that is an attraction in some bonds but also a reason that some of them have what may be viewed at first glance as ‘low yields’.

Bonds like any investment tool get ‘ratings’ by S&P, Fitch and Moody’s. The level of risk will often factor into the yield of the bond as well, General Obligation bonds are normally based on the faith of the credit of the issuer, typically this is Countries Governments (who are highly rated!), and they often have the lowest yields as they are seen as being totally secure. Basically the payment hinges on the Taxation ability of the issuer rather than on the profit of a particular project.

Revenue Bonds repay on the basis of revenue from a future project like a damn or an electricity system, Assesment bonds are based on the ability to procure a tax (for instance property tax) from the issuers boundaries.

The term ‘Auction Rate’ implies that the money is auctioned Dutch Auction style, so an inside Auction Agent will see bids coming in from Broker Dealers and they will set the rate at whatever is the lowest one which will cover the auction rate security. So to simplify that, whoever can do the deal at the cheapest prices sets the rate. The problem here is that when credibility fails and credit is squeezed the figures submitted to Auction Agents goes from being a race to the bottom (in terms of rates) into a race to the top. Credit becomes instantly more expensive and because these bonds can run in short periods as mentioned above it gives rise – during a crisis like the present one – to a systemic weakening of local and state financial health, hospitals can’t cover debts nor can other vital services that raised money on the municipal bond market.

This is part of what is being referred to when you hear about ‘rate compression’ the same fear that is causing money to not travel between financial houses, the best descriptions for the crisis at present focus on ‘liquidity’ rather than on ‘sub-prime’.

bond market on a tightropeThe Irish Government had to pay a hefty premium on the most recent bond it was 50 basis points (or 0.5%) higher than the 10 year German Bund bond, that is an attractive spread because we have a surplus and our debt v.s. GDP is good, but the scary part is that to me at least, it is indicative of a serious upcoming tax shortfall for the government, why pay such a high premium (and 50 basis points is huge in bonds!) if we are in such good shape? That move put our Government bond in with shining economies like Italy and Greece (heavy sarcasm intended).

The fixed rate markets are what keep governments afloat and that is the worrying thing about the credit crunch, we can’t print money to get out of the problem (that’s not the best solution either) , and you can’t force people to cough up cash either, you can hit your tax base but that will cause international firms to bail out and drive down long term prospects.
The solution may end up being ECB intervention of the same mode that the Fed has been taking in the USA.

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