Latest credit-market trap could hit closed-end funds
Failures of auctions to reprice this debt has already walloped municipal bonds
By Laura Mandaro, MarketWatch
Last Update: 7:45 PM ET 2/14/08
SAN FRANCISCO (MarketWatch) -- Auction-rate securities, the latest minefield in the credit market, may soon claim a new victim: closed-end funds.
J.P. Morgan analysts said Thursday they anticipated the costs from some of these funds, which had issued auction-rate securities as a source of cheap financing, could increase after the market for these securities nearly dried up.
"The cost of leverage will rise for closed-end funds," J.P. Morgan analysts Kenneth Worthington and Timothy Shea wrote in a report, noting that these higher costs "should weigh on returns."
Closed-end funds are different from their cousins, mutual funds, because they do not continuously offer shares for sale. Firms such as Eaton Vance Corp. (EV) , Nuveen Investments, Calamos Advisors and BlackRock Inc. (BLK) manage closed-end funds that have used the auction-rate market for a source of funding. They've done this by issuing what's known as auction-rate preferred shares.
"Auction failures means this preferred market may go away," the analysts said.
From muni bonds to Bristol-Myers
Once a large but formerly low-profile segment of the financial markets, auction-rate securities are the latest investment vehicles to convulse, singeing investors and cutting off financing for issuers. Municipalities, whose bonds made up many of these vehicles, have seen the rates on their debt skyrocket after investors have shunned recent auctions.
"It just speaks to the interconnectedness of capital markets," said Tanya Azarchs, banking analyst at Standard & Poor's. "This has been a little like pulling on a string."
'A year ago, no one talked about or thought about this market. It had been functioning the way it had for 20 years.'
Tanya Azarchs, Standard & Poor's
When running smoothly, the $331 billion market works the following way. An investor such as a corporate treasurer buys auction-rate securities, often municipal bonds but also sometimes preferred stock or corporate bonds. These have long-term maturities, but act like short-term investments because the holders can sell them at weekly or monthly auctions, when their rates reset. Some investment managers regarded them as a cash alternative for investors looking for safe but liquid investments.
Investors ranging from family trusts to large corporations like Bristol-Myers Squibb Co. (BMY) and 3M Co. (MMM) had used auction-rate securities to get a little more yield on their savings for not much more risk -- or so it seemed.
"A year ago, no one talked about or thought about this market," added Azarchs. "It had been functioning the way it had for 20 years."
A manager of a money-market fund that has an obligation to buy only short-term, highly rated securities could choose auction-rate securities as a place to park cash, for instance.
Closed-end funds, for their part, issued auction-rate preferred stock and used the proceeds to buy longer-term instruments for common shareholders. This use of leverage boosted the yield for common shares in these funds, J.P. Morgan said.
Bidders skip town
The problem for issuers and their investors is that the door has recently shut on those investment auctions. Investors, skittish about the unraveling in other parts of the credit market, have sat them out.
With roughly half of the outstanding auction-rate securities held by individuals, "a significant, albeit likely short-lived liquidity crunch is again emanating out of the credit markets," wrote Banc of America Securities analyst Jeffrey Rosenberg.
Past auction failures has culminated in the refusal of brokers to make a markets in these securities, Banc of America Securities said. About 80% of auctions failed on Wednesday, the brokerage estimated.
The link between auction-rate securities and the disruptions in other parts of the credit market is a complicated one, but it all traces back to the surprise surge in mortgage defaults that started last year.
Losses in pools of these soured mortgages, structured securities known as mortgage-backed securities and collateralized debt obligations, not only racked up big losses at investment banks; they also jacked up claims on the companies that insured holders of the structured securities. With a load of claims to repay, the financial standing of these bond insurers, most notably Ambac Financial Group (ABK) and MBIA Inc. (MBI) , suddenly looked shaky. Concerns about the credit ratings of the insurers, by proxy, made everything else they had insured looked vulnerable -- including municipal bonds.
Those municipal bonds, issued by school districts and county governments, are the connection with the recent collapse in auction-rate securities. They're a big part of that market. Now the risk that some of these municipal bonds might not keep their high credit ratings is keeping investors away from auction-rate securities.
"It's more about the supply-demand balance than about any deterioration in municipal-bond credits," said S&P's Azarchs.
She expects that some of the investment banks that arranged these deals -- including Citigroup Inc. (C) , Goldman Sachs Group (GS) , JPMorgan Chase & Co. (JPM) , Lehman Brothers Holdings (LEH) and Merrill Lynch & Co. (MER) -- will take some of these securities onto their balance sheet as an extension of goodwill to their municipal-bond clients.
"There could be some write-downs this quarter from any of these programs," Azarchs commented. Besides auction-rate securities, similar upsets have happened in structured vehicles known as variable-rate demand bonds and tender-option bonds. "But I don't expect them to be really large -- not like the fourth quarter."
For the closed-end funds, auction failures may mean the market for auction-rate preferred stock issuance has shut as well.
J.P. Morgan estimated that funds at Nuveen and Calamos Advisors have some of the most leverage, putting their funds more at risk for higher costs. In a worst-case scenario, if Eaton Vance were to deleverage its closed-end funds that used these securities, that could cost the publicly traded company 10 cents 15 cents a share annually, the bank's analysts said. |
