But because the notes routinely traded hands at auctions, Wall Street convinced investors that they were just as good as cold, hard cash.
Lo and behold, the $330 billion market for auction-rate notes ground to a halt in mid-February when bids for the securities disappeared. Investors who thought they could sell their holdings easily are now stuck with them. It turns out that the only thing that’s really just as good as cash is, well, cash.
While investors pray for a resurrection in the auction market, they are receiving a fixed interest rate outlined in offering documents. Historically, these securities have paid approximately one percentage point more than money market funds. Many purchasers of these notes are relatively small individual investors; several years ago, banks dropped the minimum investment in them to $25,000 from $250,000.
Municipalities and other tax-exempt institutions have issued most of the current crop of auction-rate notes. But closed-end mutual funds issued $65 billion worth. Such borrowings provide leverage to the funds, letting them generate slightly higher yields for their common stockholders.
Closed-end funds that issue auction-rate notes typically sell them in amounts worth one-third the value of their underlying assets. For example, the John Hancock Tax-Advantaged Dividend Income fund, with $1.17 billion in assets, has issued $380 million in auction-rate notes.
Owners of notes issued by closed-end funds are faring far worse than investors stuck with municipal issues. That’s because the interest rates paid on municipal notes when auctions fail are capped at as much as 12 percent, much higher than the caps on closed-end fund notes, which are currently around 3.25 percent.
In other words, holders of closed-end fund notes receive little to no premium for being stranded. Even airlines try to give you a free meal or an upgrade when they leave you at the gate. Investors are likely to remain in this vise because closed-end fund issuers have no incentive to redeem their notes since the interest rates resulting from the failed auctions are so low.
Some customers who have tried to get their brokers to cash them out say the firms have responded by offering to let them borrow against the value of these securities. At a cost, of course: the typical margin rate for borrowers is at least 7 percent at most shops. Other holders are selling the notes at a deep discount to speculators willing to buy distressed securities.
Wall Street made generous fees issuing these securities and running the auctions — as long as there were bidders. After the bidders vanished, some firms stepped in and bid for the securities for a while, giving investors a way out.
No more. What’s the sense stretching your already-thin balance sheet just to keep a market open for your customers?
In interviews, investors who own these securities say they weren’t warned that they might not be able to sell them if an auction failed. They say they were told that the instruments were as safe and liquid as — yes, you guessed it — cash.
Stephen N. Joffe, a client of UBS Financial Services, is suing the firm because it put all $1.35 million of his charitable foundation’s cash into auction-rate securities issued by Eaton Vance Limited Duration funds. This, even though he said he explicitly told the broker to take no risk and that he would need constant access to the funds.
Dr. Joffe, 65, is a former professor of surgery who founded LCA-Vision Inc., a company that operates laser vision-correction centers. “I never asked my broker to get me a better rate,” he said. “I felt the responsibility to maintain this account as a risk-free account. I believed this was in the equivalent of an overnight money market account.”
Now, the Joffe Foundation can no longer fund programs that help prevent AIDS in Africa, provide indigent people with laser vision correction and correct the cleft palates of African children.