When the auction-rate-securities market went into seizure in February and early March, it only added to the headaches of hedge funds operating in the municipal bond market, triggering prompt liquidations and $3 billion in losses.
Though hedge funds may not have had a large direct stake in the ARS market, the carryover effect from the meltdown caused such a downward spiral in muni prices that it gutted their value relative to taxable securities. This caused liquidations in the hedge funds’ highly leveraged positions in the tender-options bond market. The losses are likely to continue in the muni market, given hedge fund liquidations and the expected flood of municipal bond refinancing by issuers who have relied on ARSs for short-term financing. What’s also keeping money out of the muni market, say hedge fund managers, is the reluctance of banks to give hedge funds extensive repo lines. Uncertainty over bond insurers doesn’t help.
Auction-rate securities — introduced in 1984 and estimated by Bank of America Corp. to be a $330 billion market — are used by municipalities (as well as nonprofits, universities and closed-end muni bond funds) for short-term financing. Though they have nominal long-term maturities, ARSs are priced and traded as short-term instruments because of their interest rate reset mechanism and the willingness of investment banks to provide clearing bids to maintain a market. Until recently, most ARS investors were high-net-worth individuals and corporations, which treated these securities as cash equivalents. But corporations abandoned the market after a March 2007 decision by the Financial Accounting Standards Board to strike “cash equivalents” from cash flow and balance-sheet statements. This left high-net-worth individuals as the primary buyers. For a time, investment banks continued to submit bids to ensure that auctions would clear. But given the banks’ increasingly constrained balance sheets, they could no longer afford to do so; in February, 80 percent of ARS auctions failed. This triggered provisions that in some cases caused yields to reset at as high as 12 percent.
“Few municipalities are prepared to have their interest rate costs double or triple,” notes Robert Fuller, a principal at Hopewell, New Jersey–based Capital Markets Management. Fuller advises health care, higher education and municipality issuers, and expects ARS debt to be refinanced in the next few months. “The rate push on the rest of the muni market should be substantial,” he says.
Meanwhile, high muni yields have attracted buyers like insurance companies and fixed-income specialist Pacific Investment Management Co., which do not depend on the credit market.
Although muni rates may have bottomed relative to taxable securities, hedge fund managers caution that more turbulence may be coming, given the wave of muni refinancings, uncertainty about monoline insurers and, in particular, the bank balance-sheet problems. “It’s very difficult to get leverage right now,” says one New York hedge fund manager who spoke on condition of anonymity. “We had a bank tell us they couldn’t give us any repo lines because they were all being used by their more profitable equity fund clients.”
