Hey Dumb ARSe!

Auction Rate Securities (ARS) have recently joined the list of fixed income sectors experiencing dislocations due to the fallout created by the problems in the subprime mortgage market. Borrowers ranging from student-loan authorities to municipalities to large bond funds depend upon this market to raise money for making loans and funding projects. They do this by selling securities whose rates reset weekly in auctions held by various dealers.

The Student Loan ARS sector has been largely an institutional market whereas the securities in the Closed-End Fund (CEF) sector, featuring names such as Nuveen, Blackrock, RMR, First Trust, and Calamos, is more of a retail market. Regardless, in recent days the investors who typically buy auction-rate securities have been balking. This has created a mismatch between buyers and investors who try to sell their securities at the weekly auction, and as a result the auction(s) haven’t “cleared”.

Auctions for some Nuveen and Calamos issues haven’t cleared in the last few days when the lead underwriters failed to support the auctions.

The number of daily auctions, particularly in Student Loans sector, not clearing has increased in the past few days and will likely continue to do so in the near-term until market conditions settle down. When an auction doesn’t clear, an investor looking to sell must continue to hold some or all of their securities until the next auction and receives a “maximum” rate from the issuer. This rate is set forth in the security offering agreement and will depend upon the type of ARS.

The rate on the CEF products reset at a spread to an underlying index. Taxable CEFs such as RMR, First Trust, and Calamos are indexed to LIBOR.

The tax exempt CEFs (Nuveen and Blackrock, etc.) are indexed to the BMA (Bond Market Association) index.

Both short-term indexes will follow the direction of short-term interest rates as Central Banks change monetary policy.

Dealers in ARS (C, UBS, JPM, GS, etc.) have no contractual obligation to take the securities in. In the event an auction doesn’t clear, this has created liquidity concerns on the part of current holders. Because of these different reset agreements, there is a wide disparity in reset rates and the “maximum” rates may vary widely between the CEFs, the muni ARS, and the student loan ARS.

Auctions will continue on a weekly basis. When an auction doesn’t clear, the investor will receive the “maximum” rate until the next auction opportunity. You probably heard that the Port Authority of NY and NJ interest rate on Tuesday jumped to 20% from 4.2%. Investors will continue to receive that rate until the auction clears upon which time the rate reverts to a market rate. This “maximum” rate will act as a penalty to the issuer and should be an incentive for them to move to reduce supply by refinancing into other vehicles (collapsing deals and redeeming shares) which will help to “right-size” the market and clear the auctions.

The inability of an auction to clear has created a near-term liquidity issue in the ARS market and as a result an investor in those deals will find themselves owning securities subject to the next auction opportunity. The underlying credit quality of the issuers generally remains very high, investment grade at the least and/or some issues are involved in the government-guaranteed student loan market. As far as I have heard from my sources, the sector does not have a credit issue. The dislocations in the sector have caught the attention of the media and the rush to sell has overwhelmed the market, increasing the likelihood auctions will not clear creating a liquidity issue.

Lost in the media discussions is the fact that these instruments carry investment grade underlying credit ratings or are involved in the government-guaranteed student loan market, hence this is not a credit issue.

This period of volatility is likely to persist for the near-term, but for investors comfortable with a potential lack of liquidity that can ride this out, it may be an opportunity to benefit from attractive short-term yields.