Auction Rate Securities

Update - July 16, 2008 - While many auction rate security instruments have been retired, returning principal to investors, these instruments are now viewed as highly inappropriate for non-institutional investors. The ARS market has experienced severe difficulty, making front-page news on the Wall Street Journal. Many investors have been unable to liquidate their positions, and yields are highly volatile. Until the market sees greater stabilization and transparency, we recommend staying away from Auction Rate Securities.

What is an Auction Rate Security?

Auction rates securities are bonds whose valued are reset periodically via a Dutch auction. For the bond issuer they presented an opportunity to raise cash at lower rates, since the money was more liquid than a typical 20 or 30 year bond. For the holder, they were a way of generating a safe, liquid, and insured return that was generally higher than a CD or money market account. These securities could be issued closed-end fixed income funds that wants to leverage its portfolio, by utilities that want to borrow against future receivables, as well as collateralized debt obligations back by pools of mortgages.

Since February 2008 though, the auction rate securities market has collapsed and many investors have been stuck unable to liquidate their securities and extract their money. It is important to note that while investors have been unable to liquidate their position, their principal technically remains whole. Many large bond houses are working to try and redeem their investors money, although this is not universally true.

In the past, auction rate securities provides a very interesting investment alternative for large groups of people and institutions who believe that short-term rates are rising. Were short-term interest rates to rise quickly (or there to be expectations that they will rise quickly), the increase is immediately reflected in an increase in the clearing yield at the next auction date (which is always no more than one week away). Likewise, were short-term rates to fall or expectations about rate rises to become less enthusiastic, the impact would be reflected in a decline in the clearing yield at the next auction date. Therefore, these securities have much more volatility in their yield than online savings accounts, Short term CDs, and money market funds.

The entire size of the auction rate security market is estimated to be roughly $200 billion. Half of the market is believed to be purchased by corporate purchasers.

These securities were offered by major fixed income fund managers through Dutch auctions each week and reset on a given day of the week each week (some securities roll over every 28 days). On each new auction or reset date, the rate was reset and interest paid to holders from the prior week. If you invested in these securities, your money was ordinarily not tied up beyond the reset date.

In August of 2007, there was a run of failed auctions relating to auction rate securities secured by pools of collaterized debt obligations backed by mortgages in which investors did not show up to bid and some investors were not able to sell out on the reset. It now appears that some investors panicked at that time and sold their action rate securities at a discount to their face values. Metro PCS appears to have been one such holder that panicked - read about their suit against Merrill Lynch in "Metro PCS Sues Merrill Lynch over Risky Investment", The Wall Street Journal, October 19, 2007.

In February, 2008, this imbalance returned and caused the collapse of the Auction Rate Security market. Some have tied the collapse to a change in how auction rate secuities are classified on corporate balance sheets. Others have tied it to the turmoil in the CDO and mortgage markets and the downgrading of the bond insurance companies.

Investors may also wish to read "Auction Rate Securities: Hold that Gavel," CFO.com, April 25, 2005, which explains the potential impact on Dutch auctions of too few bidders and discusses a preliminary SEC investigation into bid rigging.

Dutch Auction Explained:

In a Dutch auction, a seller may be selling, for example, 50 notes. Four bidders are willing to buy 20 notes each. Bidder A is willing to take a return of 2.85%, bidder B a return of 2.90%, bidder C a return of 2.95%, and bidder D a return of 3%. The clearing price, or that yield at which the seller can sell all of its notes, is 2.95% - bidders A and B receive all 20 notes that they want at a yield of 2.95% (which is higher than they were willing to accept) and bidder C receives 10 notes at 2.95% (or half of the notes which they were willing to accept at that price); bidder D does not purchase (since they are not willing to purchase the notes at that price).