Auction bonds face credit crisis

Some municipalities borrowing in the so-called auction-rate debt market are seeing the cost of money recede from a recent surge, but the market remains far from back to normal, analysts said Wednesday.

Interest rates on $100 million worth of bonds issued by the Port Authority of New York and New Jersey were set at 8% in a weekly auction Tuesday, after reaching 20% on Feb. 12, according to data from Bloomberg News

The 8% rate on the federally taxable Port Authority debt still was above the range of 4% to 5.7% the agency paid until this month.

Auction-rate bonds are long-term debt with interest rates that reset according to bids submitted through securities firms every seven, 28 or 35 days. When there aren’t enough bids, the auction fails and the rate is set at a penalty level spelled out in bond documents. Investors who expected to sell the debt are left holding the securities.

The auction-rate market is the latest corner of the financial system to be hit by the credit crunch that has seen lenders and investors pull back from buying many securities.

Until the last two weeks, bankers who ran auctions prevented failures by purchasing bonds for their own account, though they weren’t required to do so. Now, the banks are balking, in part because of losses they’ve suffered in other market sectors, particularly mortgage-backed bonds.

Since the first municipal auction-rate debt sale failed in late January, hedge funds and other investors have swarmed to the market, eager to capture the uncommonly high yields.

Investors now are jockeying to bid enough to get the paper. “You bid too cheap and you get left out,” explained one market source.

Meanwhile, many closed-end investment funds that borrow in the auction-rate market via preferred stock have been frozen out of the market, leaving investors who own the stock unable to sell -- although they continue to earn interest.

Brokerage Morgan Stanley on Wednesday was among the latest firms to tell shareholders that auctions had failed for a number of its closed-end bond funds. The firm said it was “working with other participants to find ways to restore liquidity” to the market.