Our Run In With Auction Rates And What It Taught Me About Markets
Over the past month, my wife and I had a run in with the auction rate security market. We emerged unscathed but there were a few uncomfortable moments and they taught us a few things about markets that we had sort of understood but not at a gut level. There’s nothing quite like a few sleepless nights to teach you lessons you’ll keep for the rest of your life.
It all started almost a year ago, when we parked a significant amount of cash in tax free municipal bonds. The cash is intended to be used to fund a purchase we plan to make later this year. We wanted the money to be totally safe, very liquid, and produce income that we didn’t need to deal with the hassle of calculating and paying estimated taxes on. So with the advice of some experts on tax free bonds, we purchased three auction rate tax free municipal bonds.
For those who don’t know what an auction rate security is, here’s a short explanation. If you want a longer one, click on the link in that last sentence and wikipedia will do its magic for you. Auction rates are generally long term bonds (corporate or muni) that have their interest rate reset every week via an auction. This does two things. First, it allows the borrower (the corporation or municipal government) to pay short term rates on a long term security. And that can be very beneficial to the borrower. It also allows the purchaser of the bond to have much higher liquidity because the auction rate security is re-auctioned every week. So every week, you have the opportunity to say that you want out and you get out. At least in theory.
We’ve owned auction rate munis on and off for almost 10 years so it’s not like we were new to this market. But the amount we parked in auction rates last spring was significantly more than we’d had in auction rates in the past. I understood how they worked, but honestly never paid much attention to the specifics.
One specific provision of auction rates that is really important, but I honestly knew very little about until the past couple months, is the penalty rate (or maximum rate). If a bond auction does not generate enough demand at any time in the life of the bond, it’s reverts to a long term bond and pays a maximum rate of interest.
Until the recent problems in the fixed income market, brought on by the subprime mess, the auctions of these securities didn’t generally fail. There were a ton of buyers in the market and there was plenty of liquidity. But several things happened that have changed the auction rate market, at least temporarily.
First, and most importantly, the issuers of auction rate securities generally get the bonds insured against default in order to improve the credit quality and rating of the bonds. These bond insurers have gotten into trouble in the subprime mess and they are in various stages of financial distress. Without the security blanket of the bond insurer, many of these auction rate municipal bonds look a bit riskier and so the demand for them has gone down.
In addition, there is a general de-risking going on across all of the capital markets with investors opting in favor of really safe investments right now. So that further dampened the demand for the weekly auctions.
Starting late last year, auctions starting failing. And they have continued to fail for most of the first two months of this year. Investors who were sold a "safe and liquid" bond are waking up to find out that they now have a "pretty safe and illiquid" bond. They are also finding that the interest rates they are now getting have gone up.
So when I got a call from the person who manages our bond portfolio about a month ago telling me that "your bonds have not yet failed an auction but you should know that the risk of it happening has gone up", I started paying attention. I did my homework and got a list of the three bonds we owned and drilled down into the details of what they were. I focused on the borrower, the borrower’s credit, the rating, the insurer, and most importantly the penalty rate. All of our three bonds were issued by government managed utilities in NYC (like water and sewer). All were AA rated borrowers and AAA rated by virtue of bond insurance. All were insured by insurers who were in the news. But most importantly, all had penalty rates above 12%, with one at 15%.
We thought long and hard about what to do. We went for a week or two where we watched to see if the bonds would pass the auctions. In every case they did. As we noodled it over, we came to realize that the auction rates we held were really solid securities because of the penalty rate. Even though we needed the money to be liquid later this year, there were investors who would love to own the securities at a maximum/penalty rate of 12-15%. So there were investors coming into this market almost hoping for an auction to fail. That provided the necessary liquidity to the auctions of these specific bonds.
But even though the bonds were solid, the rates they were paying had gone from 3% in the fall of 2007 to over 7% in February. That’s how messed up the auction rate muni market had gotten. We were getting paid over 7% tax free for bonds that were solid. And the borrower, in our case the local government utilities, just saw their interest expenses go way up.
Ultimately, we decided to bail out of the market and now our cash is sitting in a money market fund paying a fraction of what we were getting in the auction rate market. But we decided that we should not be taking advantage of a messed up market with cash that we have committed to spend later this year. And so, along with a lot of other "safety first" money, we left the auction rate muni market last week.
The most interesting class I took at Wharton where I got my MBA was called "speculative markets" and in that class I learned that markets include different classes of investors. There is the safe money, the hedgers, and the speculators. For example, when a company (like YHOO) get a takeover bid and the stock soars, the safe money generally leaves the stock, takes its gain, and the stock trades into the hands of speculators who are now taking the risk that the deal will in fact go through. They are a different kind of investor who is getting paid to take those kinds of risks.
The same thing has happened to the auction rate security market, at least temporarily. The safe money, at least our safe money and I am sure many others’ safe money, is gone from that market. And in its place are speculators who are willing to take the risk of illiquidity and even default (which is very low in the muni market) in return for getting tax free interest rates of 7% to 15% (which are the equivalent of 10-20% taxable).
What was my big takeaway from this whole affair? When risk is appropriately priced, there is a market for something. And in the case of auction rates, the risk is illiquidity and so you must focus on the penalty rates. When they are priced appropriately, the market works. When they are not, the market doesn’t work. Thankfully the people who helped us construct our auction rate portfolio understood this. Now we do.