The tremors of the housing market and credit credit crisis hit another type of investment this week, the auction rate security market. The Wall Street Journal and several other business magazines have reported auction rate security failures for both Georgetown University and Nevada Power. On the surface, a failure in the $300 billion auction market sounds like a big problem. Is it?
Accrued Interest states that:
"Well, it turns out to not be a very big deal. Issuers will wind up having to pay a fee to their investment banker to refinance the debt, but that's manageable. Some issuers may use this occasion to call their variable rate debt and sell fixed rate debt instead, given that interest rates are low. Assuming the debt is indeed refinanced, the ARS holders who are currently "stuck" will get taken out when the bonds are called."
The comment thread that follows the article is equally instructive and demonstrates the confusion that even experienced traders and investment advisors have with auction rate securities. It appears that:
- Not all auction rate securities are backed by liquidity insurance. This means that you might be holding an auction rate security that you might not be able to sell. Some might have it and you'd have to check the specific of your auction rate security to know.
- Most of the payments and principal are protected. Most auction rate securities are issues by municipalities, colleges, or other institutions with high credit ratings. The vast majority are also backed by insurance which protects the principal and interest.
- If an auction fails, the rate on the ARS goes to the maximum, providing a nice return to holders. Some auction rates securities are resetting with yields as high as 12%.
- The issuer of the auction rate security is ultimately on the line to pay the 12% and they will not be happy. Most have call-provisions and look for them to call the bond if the auction market continues to fail. Thus, if there are above market returns, they shouldn't last long.
Be sure to check with a qualified professional before making any decision regarding auction rate securities.
Please visit the Auction Rate Security section for more information.