Seven Facts and Fiction about Auction Rate Securities

Introduction

Broker-dealers market Auction Rate Securities (ARS) to corporate clients as yieldier alternative investments to high-quality cash management vehicles. While the securities’ yield advantage over very short-duration (generally 28 or 35 days) bonds is possible, the brokers often fail to point out the price an investor pays in terms of liquidity given up, opportunities lost along the yield curve, as well as accounting complexity.
Broker-dealers have an embedded interest in marketing this product because of higher fees they receive than those from government and high-quality corporate issues. The question corporate CFOs need to ask themselves is: How do we benefit from providing liquidity for the issuers and higher banking fees to the auction dealer?
We believe a portfolio of ARS from a single auction dealer presents a unique set of risks for clients whose primary objectives are preservation of capital and sufficient liquidity.
Below we examine the seven claims broker-dealers frequently pitch to corporate investors, and the facts about the true risk and reward of ARS.

1. “ARS are highly liquid”

FACT: ARS were created so that investors replace traditional liquidity providers (banks) as the primary supplier of cash for states and towns in certain activities such as student loans. Investors need to understand that unlike taxable variable demand notes (VRDNs), ARS are not legally putable.
ARS gained popularity after municipal issuers found banks either raised the prices of providing backup liquidity, or simply refused to issue lines of credit all together. The backup liquidity is necessary should an investor decide to put a VRDN back to the issuer. By eliminating the put feature, investors’ ability to get out of an ARS is at the mercy of the auction dealer and the success of each Dutch auction.
There is not a reliable, or liquid, secondary market for ARS. The fact that money market funds (2a-7 funds) are barred by the SEC to invest in the asset class eliminates the largest group of liquidity providers for this product.

2. “The auction dealer will buy back your bonds at par”

FACT: Auction dealers may agree to buy back bonds from investors in order to sup-port the market, but they are under no legal obligations to do so, nor are they committed to pay you at par. Since a single dealer generally markets ARS exclusively, other dealers are unlikely, and unwilling, to bid on the securities of other dealers. Investors need to analyze the creditworthiness of the dealer prior to investing to ensure the dealer will main-tain adequate liquidity and market mak-ing capabilities for the duration of the investments.
Sometimes even a financially sound dealer may decide not to support liquidity for ARS due to business concerns. There is no legal recourse against them if this situation does occur.
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