Sunday, June 8, 2008

Auction-Rate Securities: Why are they in the news and when to do they make sense? (a)

What are “Auction Rate Securities”
An auction rate security (ARS) typically refers to a debt instrument (corporate or municipal bonds) with a long-term nominal maturity for which the interest rate is reset through a dutch auction. In a dutch auction, existing holders and potential investors enter a competitive bidding process through broker/dealer(s). Buyers specify the number of shares, typically in denominations of $25,000, they wish to purchase with the lowest interest rate they are willing to accept.

Each bid and order size is ranked from lowest to highest minimum bid rate. The lowest bid rate at which all the shares can be sold at par establishes the interest rate, otherwise known as the "clearing rate". This rate is paid on the entire issue for the upcoming period. Investors who bid a minimum rate above the clearing rate receive no bonds, while those whose minimum bid rates were at or below the clearing rate receive the clearing rate for the next period. ARS holders do not have the right to put their securities back to the issuer; as a result no bank liquidity facility is required.

There is absolutely nothing inherently wrong with auction bonds, the problem arises from the way in which people were sold them and the way the markets viewed them. Everyone looked at these as Money Market alternatives. Everyone thought that they had the same liquidity as a Money Market or even a Bank account… but with a better rate. What they recently learned is that auctions can “fail” and when this happens they can’t get their money on-demand.

Failed Auctions
If there are not enough orders to purchase all the shares being sold at the auction, a failed auction occurs. In this scenario, the rate is set to the maximum rate defined for the issuer (typically a multiple of LIBOR or the TBMA index). The purpose of the higher rate is to compensate the holders who have not been able to sell their positions. Broker-dealers usually bid on their own behalf to prevent failed auctions from happening. This made failed auctions extremely rare, although they did occur rarely. In 2008 the market froze when broker-dealers withdrew.

Beginning on Thursday, February 7th, 2008, auctions for these securities began to fail when investors declined to bid on the securities. The four largest investment banks who make a market in these securities (Citigroup, UBS AG, Morgan Stanley and Merrill Lynch) declined to act as bidders of last resort, as they had in the past. This was a result of the scope and size of the market failure, combined with these own firm's need to protect their capital during the 2008 financial crisis.[citation needed]

On February 13 (2008) 80% of auctions failed. On February 20th, 62% failed (395 out of 641 auctions). As a comparison, from 1984 until the end of 2007, there were a total of 44 failed auctions.

Cheering for “Failure”
A “failed” auction can be good for you. Here’s why. As discussed above, when an auction fails the ARS holders receive the maximum rate defined by the issuer. This is usually a rate well-above market rates so your clients receive a premium for holding the paper until the next successful auction.

The downside of failure? You can’t sell your securities… but you’ve been paid a premium for this illiquidity!

Typical Yield Premiums… and their costs
In mid-may 2008 the Schwab position-traded municipal money market funds were offering yields ranging from 2.38% (for the Institutional Shares) to 2.17% (for Value Advantage). However, ARS yields were ranging from the high 2’s% to the low 3’s% for investments of $25,000. In other words, ARS could provide a yield premium of 60bps to 100bps. But good things come with a cost which, here, are two-fold:

  • You don’t have complete liquidity
  • You need to manage the portfolio… deciding before the weekly auction date if you want to purchase or sell.

As always, give us a call if you have any questions.

Bob Weins

(a) I would like to give credit to for the introduction to ARS and the statistics on failed auctions.