Some short-term municipal borrowers saw their costs shoot skyward in recent weeks, as the yields on tax-exempt auction-rate bonds have reset higher and higher. Market sources say a lingering wariness about the auction-rate structure, along with a decline in corporate profits and year-end budget cycles, have combined to cause the spike. Yields on the auction-rate bonds reset on a weekly basis shot up 64 basis points between their Nov. 7 and Nov. 28 auctions, and the yields on bonds auctioned monthly have jumped 80 basis points, according to an index maintained by the Securities Industry and Financial Markets Association. The increase represents a steep climb for bonds that typically yield 4% or less. While the yields on standard variable-rate bonds are reset periodically based on a benchmark index, auction-rate bonds are reset at each auction through a new process of bids and orders. Unlike their variable-rate cousins, auction-rate bonds typically do not carry a put option — one of the key differences between the two that has driven up the yields on auction-rate bonds. The difference between variable-rate and auction-rate yields has been minimal in past weeks. The difference between SIFMA’s seven-day auction-rate index and its SIFMA swap rate — a proxy for the variable-rate market — was three basis points on Nov. 14. The auction-rate index shot up to 28 basis points higher than the swap rate on Nov. 21 and was 45 basis points above the swap rate last week. “It’s boiled down, at this point, to either having a put feature or not,” said Rob Novembre, director at Citi. Global market scares and a few failed auctions in other taxable, asset-backed markets have some investors worried about the auction process itself, he explained. “We don’t know if it will be like this forever or if this is just a knee-jerk reaction to what is going on with the general fears of liquidity and credit in all markets,” Novembre said.
Municipal money-market funds, one of the largest buyers of variable-rate bonds because of the put option, are not eligible to purchase auction-rate bonds. This means that the buyer base for auction rates is composed mainly of high-net-worth retail clients and corporations looking to get a tax benefit on some of the money they have made in profits. But profits have been down during the last few months, meaning there are fewer companies looking to put their money in auction-rate municipal bonds, sources said. Corporate profits were about $1.6 trillion for the third quarter, which was a $19.3 billion drop from the second quarter, according to a report published last week by the U.S. Department of Commerce. Additionally, for broker-dealers and other companies that mark the end of their financial year in November, year-end cash management practices saw companies looking to get securities off their books, in favor of holding cash, sources said. “In order to prevent an undue increase in the rate or a failed auction, the auction agents have historically stepped in to buy the bonds,” said Matt Fabian, managing director at Municipal Market Advisors. “There is concern that some of the auction agents won’t be able to do that forever because their balance sheets are constrained.” Some of the nation’s largest broker-dealers, such as Citi and Merrill, Lynch & Co., have taken multi-billion write-downs on the value of mortgage-backed securities that they own. The recent auction-rate volatility has many state and local governments watching their resets carefully. New York’s Metropolitan Transportation Authority, for example, saw a series of auction-rate bonds it issued earlier this year reset as much as 70 basis points higher over the course of a month. Auction-rate volatility prompted Chicago Public Schools officials to hold off on a planned $150 million auction-rate sale. The tranche is part of a larger overall issue of $400 million of new-money debt the district is selling to finance ongoing capital projects. The fixed-rate piece, about $250 million, priced earlier this month with Loop Capital Markets LLC as senior manager. The Chicago Board of Education planned to follow that sale with the auction-rate piece but decided to hold it after a review of current rates and market demand. “We will evaluate the deal after the end of the year,” said debt manager Sandra DeAngelus. The deal was to be underwritten by Merrill, and Ambac Assurance Corp. was expected to insure the bonds. Many auction-rate issues, such as the Chicago schools deal, are backed by triple-A bond insurers. Novembre said, however, that worries about the insurers’ financial strength has not been a factor in the recent uptick in auction-rate yields. “We actually are not seeing any kind of dramatic push-back on any of the monolines,” he said. “There isn’t really any discrimination at this point.” Yvette Shields contributed to this article.
