Auction-Rate Market Shrinks 18%

As Citigroup predicted last week, the $330 billion auction-rate securities market is ceasing to exist. About 18% ($58.9 billion) of the securities outstanding in January have already been redeemed or will be converted by municipalities and closed-end mutual-funds. In addition, the SEC, FINRA, and at least 10 states are investigating brokerage firms to see if they misrepresented the securities to investors and criminal charges may be filed by the states.

Municipalities nationwide sold their bonds during the past two months to refinance auction debt as investors took advantage of tax-exempt yields that rose to a half-percentage point above taxable Treasuries. Yields on 10-year top-rated tax-exempt debt ended last week just 0.03 percentage point higher than the rate on the Treasury note and about 0.6 percentage point less than Treasuries over the past seven years. This reflects fading concern that auction-rate refinancing would overwhelm demand.

Rates on auction debt have fallen as borrowers such as Puerto Rico bid for their own securities as a temporary tactic to normalize rates before refinancing the bonds. By the end of next month, $48.3 billion of municipal auction debt is expected be to be converted by borrowers.

New York-based BlackRock said its closed-end funds plan to buy back $1.87 billion out of the $9.8 billion preferred auction-rate securities they issued and it wants to issue about $1 billion of floating-rate securities (aka tender-option bonds) to provide cash to some investors stuck in its tax-exempt preferred shares. Additionally, BlackRock and nine other fund managers plan to redeem at least $10.6 billion in taxable and tax-exempt preferred auction shares. And along with fund advisers such as Nuveen Investments, BlackRock is exploring options to add a “put” feature that would allow investors, including money-market funds, to sell the securities back to borrowers when rates reset.

According to strategists at Lehman Brothers, municipal bonds produced returns of 4.64 percent since the end of February, better than all other fixed-income asset classes. Lehman predicts that returns will increase as municipalities revert to sub-Treasury yields.