Municipal Bondage

Story Highlights:

• Certain municipal issues are failing to find buyers, resulting in more "failed auctions."
• Worries about the bond insurers who back these bonds are keeping buyers on the sidelines.
• Investors with longer-term objectives are swooping in to take advantage of penalty rates, which can be much higher than market rates.
• While this could be an issue for short-term investors deeply involved with the bonds, the stock market and broader economic impact of these failed auctions is almost non-existent.

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Most investors consider municipal bonds, or "munis," safe investments. In fact, on a safety scale, most view muni bonds second only to US Treasuries. After all, long-term traditional muni default rates are a measly 0.1% or lower, according to Moody's. Recently, some muni bonds are under the microscope because of a recent spike in failed auctions for a variety known as "auction-rate munis." These securities are a popular vehicle for investors looking to park cash.

Muni Bonds Lose Buyers As Credit Crisis Spreads
By CNBC.com staff

Recent auctions have failed to attract enough buyers willing to purchase all the securities offered for sale—mostly because of fear surrounding possible bond insurer downgrades. This results in a "failed auction." When an auction fails, the interest rate paid for the upcoming period defaults to a pre-determined penalty rate—the bond issue is then basically in "bondage" until a successful auction takes place. Many investors fear the inability to sell their shares at auction indicates the price of the securities will plummet. In reality, investors who don't need immediate access to their cash often make out like bandits. That's because the penalty rate can be much higher than prevailing market rates, so investors receive a better return on their investments until a successful auction is held. We can hear long-term investors now, "Thank you sir may we have another! Another failed auction, that is." As usual, it didn't take long for nimble investors to recognize a great investment opportunity.

Auction-Rate Bonds May Come to Rescue, Sophisticated Buyers Begin to Show Interest
By Stan Rosenberg and Romy Varghese

So what does all this hullabaloo mean for stocks? Short answer—nothing. According to Bloomberg, the estimated size of the auction-rate muni market is roughly $300 billion—a mere pittance compared to the size of the total debt market, not to mention the global equity markets. The main risk to a long-term investor is if the issuer becomes insolvent. Since these securities are auctioned at par value, there's little risk to investors' principal unless the securities are sold outside the regular auction or the issuer defaults. However, the problem here doesn't seem to lie with credit quality or default risk, it lies in a temporary lack of demand. Regulators are taking a "regulate first, ask questions later" approach.

Muni Regulators Seek Disclosure on Auction-Rate Bonds
By Michael Quint

We're all for more information, and its possible transparency regarding bidders and sale orders can ease future concerns about getting "stuck" with these bonds. Because these issues have been receiving a lot of press recently, auctions are drawing an inordinate volume of securities for sale. As a result, more auctions are likely to fail in the near future until the volume of selling abates or higher rates attract enough buyers to make auctions successful.

Eventually, market forces should normalize the environment. How long this will take is anyone's guess. Ultimately, with the benefit of capitalism, it is likely the current "municipal bondage" won't last forever.