Auction-Rate Securities

I’ve been hearing a lot the last couple of days about auction-rate securities (big article on section C1 in the Wall Street Journal [Money & Investing] for Thursday February 21st). Could someone explain how these work? Could an investor potentially buy a long-term lumpsum of say, $100K (Port Authority NY-NJ), and get a considerable yield and hold it until maturity? FYI: I work for a discount brokerage firm, got a question on this today, went to our clearing firm for questions, and they weren’t too helpful… This information is more for my own knowledge!

No, you cannot lock in a long term rate. The prices reset (via auction) on a set time period. Typically 7 through 28 days. You have a few options at each auction date (buy, sell hold). If you “hold” you will hold at whatever the auction clearing rate is. If the auction fails you hold at the maximum rate. A lot of new buyers have entered the market over the last week or so in order to pick up some attractive yields, and from what i’ve heard the number of auctions failing has cooled a bit.

I can give you basic knowledge as I’ve just learned about them myself. Issuers such as the Port Authority will do a bond offering and the payments that they make will reset at an auction every so often (7, 35 days etc). The advantage for them is that they can issue long term debt at short term yields. The buyers of this auction paper look (or they did look) at this investments as “cash+”. Relatively safe investments that were higher yielding then other short term instruments. Now say company A buys Port Authority’s auction debt for a term of 35 days. If after 35 days there’s an auction and the auction fails (due to lack of interest) they are rolled into keeping the debt until the next auction. In which case there are some provisions where the interest rate will jump to a higher rate (as compensation). In the Port Authority’s case it went to 20%. Now company A might not want the 20% b/c of liquidity concerns and a hedge fund will come in to buy it and the higher interest rate. In the past the Investment Bank would intercede whenever an auction failed to prop up the market. They got in trouble for this 2 years ago as it wasn’t known they were doing the bidding and it gave a false sense of liquidity.

I’m confused? Do the price swings of the bonds themselves between resets reflect a long term yield at the higher rollover rate? Can you give some examples of the profit & loss possibilities of buying these now?

virginCFAhooker Wrote: ------------------------------------------------------- > I’m confused? Do the price swings of the bonds > themselves between resets reflect a long term > yield at the higher rollover rate? Can you give > some examples of the profit & loss possibilities > of buying these now? Depending on the terms on the issuance the rate will reflect to a higher yield. If say the owner of the Ports Authoritys paper is now getting a higher rate but due to liquidity concerns will turn over the paper to a hedge fund. Now if the auction fails again the hedge fund will have the paper. Not all this paper will reset to crazy rates though.

BTW Hooker what was your previous handle on OT?

I understand the mechanics of all this, but does anyone know how you actually go about buying these?

Well I would imagine that those looking to buy are contacting whoever lost the game of “musical chairs.”

Tobias: Money market brokers/dealers sell auction-rated securities. Many corporations do (did?) buy them as short-term investment vehicles, as they pay a slight (now wider) premium over commercial paper.

Blue, I mean Pink, gave a good description. I will add that an Investment Bank acts as the remarketing agent during each auction and have actually been holding a lot of these bonds since the insurers started getting downgraded. As soon as the monolines started having issues, money market funds started throwing these securities up (as one banker put it). These municipal securities are typically issued with a number of options to the underlying issuer. For instance, they can switch interest rate modes to either a fixed rate or to a VRDO (variable rate demand obligation). The VRDO structure will have a liquidity enhancement agreement provided by a bank that says that the bank will step in and buy the bonds if the market dries up. The rates on these bonds are also reset every 7 to 35 or so days. These have traded a little better depending on the “out” provision included in the contract. The liquidity provider typically has the ability to terminate the agreement if the insurer’s rating falls below a certain level. Historically it has been thought of as a kiss of death if the remarketing agent either let the auction fail by not providing a bid or let the bonds be put to the liquidity provider (if bonds are held under the liquidity facilty they reset to a higher rate). Although the banks got in trouble a little while ago for participating in the auctions, they have continued to do it. With so many issues in the market, banks have been holding a lot of these bonds and now can’t support the market because of capital constraints. Now they are both letting auctions fail and are letting bonds be put to the liquidity provider. Both of these actions have significantly increased borrowing costs for issuers. There is a mad dash for pretty much every issuer to either change interest rate modes or altogether refinance their auction rate bonds. A lot of issuers are now going for the bank letter of credit VRDO mode, which provides both credit and liquidity enhancement to the bonds. If you are able to participate in one of these auctions and get a handsome rate, it won’t be for long because the issuers are doing everything they can to get rid of their high interim borrowing costs. By the way, you can search for these things on Bloomberg and find out the remarketing agent, the remarketing/auction dates, last coupon, etc.