When AAA Does Not Mean Roadside Peace Of Mind

Introduction

Corporate treasurers frequently make investment decisions based on debt ratings from nationally recognized statistical rating agencies, namely Moody’s, Standard & Poor’s, and Fitch. This article addresses the credit risks of Auction Rate Securities (ARS) that are not adequately addressed by long-term credit ratings alone in short-term investment selections.

Long-Term Ratings Do Not address Short-Term Risks

Long-term ratings on auction rate securities do not specifically address the near-term risk to most auction rate investors; that is, the timely payment of principal and interest at the end of a rate reset cycle. We learned from the rating agencies that such ratings are based on a security’s final legal maturities, not on the reset dates. This is an important distinction since the majority of auction rate buyers do not intend to hold the bonds beyond money market terms of 13 months.
The rating misconception came to our attention after we observed sales literature from the broker-dealer community promoting ARS with AAA long-term ratings as high-grade alternatives to money market funds. We suspect that claims of this nature create a false sense of security for an investor who is either unfamiliar with the distinctions between long and short-term ratings or is inexperienced in structured finance transactions.

Auction Rate Securities Do Not have Short-Term Ratings

To gain a better understanding of rating limitations in ARS, one needs to be cognizant of a separate set of rating designations by major rating agencies for short-term risk. Generally speaking, debt rated A-1/A-1+ by S&P, P-1 by Moody’s, and F-1/F-1+ by Fitch is considered of highest credit quality.
While long-term ratings reflect both the likelihood of default and any financial loss suffered in the event of default, short-term ratings place more emphasis on the probability of default due to lack of liquidity. The short-term rating process relies on available liquidity support, either internally or externally, to meet the issuer’s obligations in a timely manner.
Unlike most corporate and municipal securities, auction rate products do not have short-term ratings, since rating agencies never view these as short-term debt. This deficiency makes it difficult, and irrelevant, to compare their short-term risk to that of other asset classes. Without external liquidity and support, we believe the credit quality of ARS is significantly less than A-1/P-1 thanks to below investment grade servicer risk and its reliance on investor confidence.
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