Wednesday, February 20, 2008

Auction Rate Stress Continues: Muni Bond Funds Impacted

As auctions continue to fail many municipalities are getting stuck with paying the default penalty rates. When no bidders emerge, the rates rise to very high levels for these securities which most issuers can not afford. This is likely to lead to a downward spiral of massive selling, a situation which would totally tank the industry.

Are local governments actually under such stress that projects are unlikely to fulfill their financial obligations? Clearly this frightening statement is the markets current take on the situation. The failure of the auctions is not really a reflection of the probable collapse of the bond insurance companies such as MBIA because some of the offerings are not insured. With both insured and uninsured muni bonds failing in the auction; this can only leave investors wondering if the systemic risk is increasing as the chaos continues. It appears that the pervasive fear has caused the collapse of all efficiency in the auction rate market.

A New York Times article points out the Closed End Muni Bond funds are the most impacted vehicle; all 102 auctions related to these securities failed on Tuesday. Despite having default penalty rates set to under 3.5%, the leveraged municipal bond funds will likely to be forced to redeem their preferreds, a situation that does not help the common or preferred shareholder.

This leads to some possible opportunities with leveraged Closed End Muni Bond Bunds. The ETF Connect site provides the capability to view the funds that utilize auction rate markets. Click on the auction rate tab on the right and select all tax-free funds in the screen. The results enable investors to review the recent winning rate and the day of the auction. Many of the rates above 3 percent demonstrate failed auctions with yields now set at the default rate.

Even more interesting is the potential of Muni funds with a large amount of BBB and below debt, whose auctions have not failed yet, to experience downside over the upcoming weeks. The PIMCO Municipal Advantage Fund (MAF) has over 30% assets in low graded bonds while the gap between the share price and NAV price has closed to the smallest discount in over a year. Any adverse event is likely to cause the price to drop despite the fund’s current 5.54% distribution rate.

Both the Van Kampen Muni Trust (VKQ) and Van Kampen Muni Opp (VMO) funds face a similar scenario. Both have over 20% of assets in low rated debt with a share price at the highest level relative to NAV in over a year. Upcoming auctions are likely to fail leaving these funds with potential downside despite their high distribution rates.

Unlike stocks, Closed-End Muni Bond funds don’t tend to move greatly in price. How much potential downside is available for shorts? On Wednesday and Thursday of last week, all of these funds have experienced large down days when the news of failing auctions spread throughout the market (see - More Credit Turmoil: The Muni Auction Rate market freezes). Most dropped 50 cents (4%) or more on an event that did not directly impact these particular funds at this point. As auctions fail on instruments offered directly by these funds, the fund prices should continue to drop. The question being – how much downside is left?

At minimum investors should expect the price to move back to the traditional statistical discount to NAV and then sink below this level. The price for these funds are likely to re-test two year lows as the fund managers struggle to redeem their preferred securities and are apt to reduce outgoing interest payments to the common share holders. The MAF fund is currently priced near $12.90 and the probable target price near a two year low is $12.00 with a likely yield rate rising near 6% after a price reduction. Most of these funds trade only 25,000 shares in volume each day on average, this however is enough liquidity to enable the creation of a short position. Investors will have to determine if the potential reward of approximately a dollar per share compared to the possible rebound risk makes it beneficial to short these securities over the upcoming weeks.

Disclosure: The author does not have a position in any of the equities mentioned in this article. The information provided does not constitute a solicitation to buy, or an offer to sell securities.


GregB said...

The "Outside the Box" newsletter had an article from David Kotok this week that discussed the auction rate problems and their impact on Closed End Muni funds.