Adding Insult To Injury: Auction-Rate Bond Investors Get Almost 0% Interest On Securities They Cannot Sell
More than $9 billion in auction-rate bonds issued by student loan agencies have left investors with bonds that pay less than the 0.76 percent interest rate of the one-month Treasury bill, reported Bloomberg.com on April 25. “It's hard to explain, to conceptualize or even understand how someone can borrow money and not pay you interest,”' said Mike Saunders, manager of student-loan bonds for Acton.
The problem materialized because of a formula designed to ensure that borrowers do not pay more interest on their debt than they receive from student-loan clients. The formula is based on a 12-month average of benchmark money market yields, which have fallen drastically as the Federal Reserve slashed its target rate for overnight loans between banks in September 2007.
Auction-rate bonds are long-term securities whose rates are determined through bidding run by dealers every 7, 28 or 35 days. When a sufficient number of buyers fail to bid, the auction fails and the rate resets to a level set out in the original terms under which the auction-rate securities were sold.
The $330 billion market collapsed in February after investors spurned debt and dealers that had routinely stepped in as buyers of last resort stopped doing so because of subprime-related losses. The collapse of the auction-rate market drove interest costs paid by states, hospitals and student-lending agencies as high as 20 percent and trapped investors in the securities. As the formula took effect in student loan auction-rate securities, however, the rate for those instruments dropped to zero.
``The investor loves you when he sees the 10 percent coupon, but how do you explain to him that it's gone from 10 percent to zero?'' Saunders queried.
According to data compiled by Bloomberg, more than 60 percent of the thousands of auctions conducted weekly since February 13 have failed. The collapse has left student-loan issuers unable to raise additional capital in the market. For the first time in 40 years, no new municipal bonds or auction-rate debt backed by student loans were sold in the first quarter.
“We need bonds that are out there for 30 to 40 years,” says CFO of NorthStar Education Finance Inc., Jamie Wolfe. “That's what these auction bonds do for us.”
A compilation of disclosure notices by Bloomberg shows that cities, hospitals, universities and other municipal borrowers have redeemed or plan to refinance at least $54 billion of auction debt by June 2. Providing limited relief to some investors, JPMorgan Chase & Co. announced that it will buy as much as $1.1 billion in auction-rate notes from three student-loan trusts.
