By Simon ConstableIs it déjà vu all over again in the debt market? You’d be forgiven for thinking so, especially if you remember the auction-rate securities debacle from 2008.
Those securities were and are used by some tax-exempt organizations as a form of inexpensive financing. They price using a Dutch auction at periodic (usually short) intervals.
Back before the credit crunch they were considered so solid that institutions and wealthy individuals treated them the same as they would cash.
Everything was fine, right up until when it wasn’t. In early 2008 the auctions failed and broadly speaking the investors couldn’t get their money back immediately. The market for these securities is essentially the same, but it’s actually working now, and if you think no one would invest in these things again you’d be wrong. They’ve shown up again in at least one mutual fund. The auction-rate market is alive and apparently well.
Duane McAllister, co-manager BMO Intermediate Tax-Free Fund (MITFX), says about 4% of the approximately $1.3 billion under management in his fund is in auction rate securities.
He notes that back in the day (2008) it never made sense for the notes to trade as a cash-equivalent. But the market has now stabilized, he said.
McAllister says two years ago he didn’t own any, but started to get interested about 12 months ago when he thought interest rates would edge higher.
Why is he holding securities with such a lurid history? This is one way to hedge higher interest rates, he says.
As interest rates rise these securities will reset, protecting the holders in a way that long-term bonds simply cannot as bonds lose value when rates rise. The cost of this insurance: Lower yield now.
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