U.S. municipal bonds are headed for their worst month in more than four years after collapsing demand for securities with rates set at periodic auctions sent debt costs for state taxpayers and hospitals as high as 20 percent.
State and local government bonds fell 4.17 percent through yesterday, including reinvested interest, based on Merrill Lynch & Co. data. That's the most since July 2003, when they tumbled 4.59 percent. Florida had to pay 5.35 percent yesterday to sell 30-year fixed-rate general obligation bonds, almost three- quarters of a percentage point more than at its Feb. 6 sale.
The $330 billion auction-rate market froze after dealers stopped purchasing the bonds when buyers failed to bid. Their lack of support has spread to the broader tax-exempt market, sending yields soaring. Borrowers from California to New York City plan to convert the securities to longer-term debt, raising concern that a flood of bonds will overwhelm already sparse demand from banks and hedge funds.
``We're going to get smashed with new-issue volume from all these auction-rate bonds'' that are being converted, said Brian Battle, a trader and vice president at Performance Trust Capital Partners in Chicago.
Yields on top-rated, fixed-rate bonds due in 30 years rose to the highest since August 2004, reaching 4.89 percent yesterday, based on data from Municipal Market Advisors. A Bloomberg index of variable-rate demand note yields jumped almost 2 percentage points to 3.17 percent.
``The damage has been unbelievable,'' said George Calvert, who manages $350 million of municipal bonds for Trusco Capital Management in Richmond, Virginia.
Subprime Fallout
The auction-rate turmoil and slump in municipal bonds are the latest examples of how the fallout from subprime-mortgage delinquencies has spread, touching a market whose credit quality is typically second only to the U.S. government.
For at least a decade, auction-rate bonds allowed municipal borrowers, closed-end funds and student lenders to borrow long term while getting short-term rates. The securities have rates that are determined by bidding that typically occurs every seven, 28 or 35 days. When there aren't enough buyers, the auction fails and rates are set at a level spelled out in official statements issued at the initial bond sale.
Auction Failures
Failures have increased as subprime-related losses at bond insurers led investors to question their creditworthiness and to shun securities carrying their backing, and banks refused to step in and buy unwanted bonds as they had in the past.
Dealers including Goldman Sachs Group Inc., Citigroup Inc., UBS AG and Merrill Lynch & Co. stopped using their own capital to support the sales, allowing some yields to rise to 20 percent. Investors and borrowers never knew the extent that banks propped up auctions because of scant public disclosure of bidding.
``I didn't understand who I was bidding against, and you never got any color on what had happened, so I just walked away from it several years ago,'' Calvert said.
At least 60 percent of each day's auctions failed to attract enough bidders since Feb. 13, based on Bloomberg and Bank of America Corp. data. There were fewer than 50 failures total from 1984 through 2007, Moody's Investors Service said.
The four largest agents that take orders from dealers and determine winning rates reported failures on 432 of 667 auctions yesterday, or 65 percent, figures compiled by Bloomberg from Deutsche Bank AG, Bank of New York Mellon Corp., Wells Fargo & Co. and Wilmington Trust Corp. data show.
The auction turmoil may raise borrowing costs for the North Texas Tollway Authority, the New York State Thruway Authority, California and Puerto Rico that plan to sell as much as $6.4 billion of fixed-rate bonds next week.
Nowhere to Turn
Fixed-rate municipal bond sales totaled $18 billion this month through yesterday, down 38 percent from the same month in 2007, according to Bloomberg data.
``Every alternative we turn to is worse than it was a year ago,'' said Roger Anderson, executive director of the New Jersey Educational Facilities Financing Authority, which sells bonds for colleges in the state.
Buying letters of credit to back variable-rate demand notes or insurance from two bond guarantors that continue to write policies, Financial Security Assurance Inc. and Assured Guaranty Corp., also has gotten more expensive, Anderson said.
'Free Fall'
While households hold most of $2.6 trillion in U.S. municipal securities, either directly or through funds, rising demand from banks, hedge funds and other institutional investors dominated the market in recent years.
By borrowing at variable rates to buy higher-yielding long- term debt, they helped absorb the record $430 billion sold in 2007 and drove state and local debt to outperform Treasuries and corporates three straight years through 2006. Since then, municipal bonds gained 1.3 percent and their taxable counterparts rose 9 percent, Merrill data shows.
The unwinding or attempts to unwind such trades by hedge funds may be exacerbating the declines, investors said.
``The municipal market in the last week and a half or so has been in a free fall,'' Warren Pierson, vice president and municipal portfolio manager at Robert W. Baird & Co., said in an interview from Milwaukee.
To contact the reporter on this story: Jeremy R. Cooke in New York atjcooke8@bloomberg.net .
