The Nascent Secondary Market in Auction-Rate Securities

The Restricted Securities Trading Network in auction-rate securities has been up and running now since March, with 7-10 transactions taking place per day. That’s not an enormous number of trades, but it’s enough to see pretty clearly what the clearing price is that the market puts on these things. And the numbers aren’t pretty.

Municipal auction-rate securities trade at a discount of between 0% and 10%; auction-rate preferred securities trade between 10% and 20% below par; and student loan auction-rate securities are changing hands with a discount of 25% and upwards.

When any fixed-income prouct starts trading in the low 70s, that counts as distressed. And clearly there’s a correlation between price and perceived credit risk here. But it’s not simply the normal, obvious correlation, where the price simply falls so that the investor can be paid to take on credit risk. Rather, auction-rate securities with non-zero credit risk are the last auction-rate securities that anybody really wants to buy. And if you do buy them, you have no idea when or whether you’ll ever be able to sell them. The interest rates might be attractive, but without an exit, you need to be brave indeed to enter this market.

As a result, a small amount of credit risk can have a huge effect on price, and it makes sense for prices to drop to a level where the investor would be comfortable buying a perpetual bond from that issuer. The securities were designed, of course, not to behave as perpetuals but rather to behave almost like cash, with incredibly short maturities. What’s more, they were never designed to trade, per se: why would you ever need to sell one on the secondary market, when you can simply not bid at the next auction? The idea that everybody would stop bidding at once didn’t seem to occur to the designers.

As a result, the market in these things is thin indeed. If I held a portfolio of them, I wouldn’t be particularly happy marking to the RSTN prices, but then again they’re probably the closest thing that the market has to public marks, so I might not have much choice.

I also worry about the brokers who put their clients into auction-rate securities, and who until now have at least offered to lend against the "cash-like" investments which have been "temporarily" tied up. If those investments are now trading hands at 80 cents on the dollar or lower, I can’t imagine many brokers lending much more than that. Do they still claim to be "scrambling" to solve this problem? I still haven’t seen any evidence of that.

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