Auction rate preferred shares – an investment vehicle touted as safe and highly liquid – have turned out to be much riskier than some investors were led to believe. Auction rate preferred shares can be only sold during auctions, and because of turmoil in the credit markets and the actions of some investment banks, recent auctions have failed.
Many investors who bought auction rate bonds were led to believe that these vehicles could be easily redeemed, and now they are finding out otherwise. The situation is already getting the attention of state authorities. Massachusetts Secretary of State William Galvin on Feb. 20 asked nine fund companies for information about failed auctions that left investors unable to sell their holdings. Ohio Attorney General Marc Dann also told reporters last week his office may file lawsuits after state funds bought the securities.
“We know that the market has more or less ceased to exist,” Galvin, the top securities regulator in Massachusetts, told Bloomberg.com. “Our concern is about small investors who may have been attracted to closed-end funds because of their reputation for reliability.”
Auction rate preferred shares are long-term corporate bonds, municipal bonds and preferred stock on which the interest rates are reset periodically based on bids submitted through securities firms. Generally, rates are reset every seven, 14, 28 or 35 days. In the past, auction rate preferred shares have been popular with institutional investors due to their low financing costs and the fact there are usually fewer parties involved in the financing process and no requirements for third-party bank support.
According to Bloomberg.com, mutual fund companies such as Nuveen Investments and BlackRock Inc. sold about $60 billion in auction rate preferred shares to raise additional capital for their closed-end funds, which also have common shares traded on exchanges. Auction rate preferred shares can only be sold on days the rates reset, but lately these auctions have failed. Failures of such auctions used to be rare, but with the turmoil in the credit markets, they have become more commonplace.
In the past several weeks, auctions of these securities haven’t been successful because of worries that bond insurers guaranteeing many of the $330 billion in outstanding auction bonds would be downgraded. Bloomberg.com has also reported that brokers such as Goldman Sachs Group Inc. and Citigroup Inc. also purposely permitted the auctions for preferred securities, which aren’t insured, to fail by not committing their own capital to sales when there weren’t enough bidders. Now, there are no buyers for auction rate preferred shares at rates investors currently holding them find acceptable. As a result, the market for auction rate bonds has pretty much vanished, leaving a lot of small investors holding auction rate preferred shares they once thought were safe vehicles with no way to sell them.
According to The Wall Street Journal, last year, when some money-market funds turned out to hold some mortgage-backed securities and faced a liquidity crisis, their sponsors stepped in and redeemed the shares at face value. But investors holding auction rate preferred shares won’t be seeing such a rescue anytime soon. According to The Wall Street Journal, Merrill Lynch and the other big banks that sold these shares have stopped making a market in them, which is a major reason the auctions have failed. When the Journal asked Merrill Lynch to comment, the brokerage only said “We are offering our clients loans which can give them liquidity.” It wasn’t yet clear whether these would be interest-free loans, the newspaper reported.
