Sunday, August 17, 2008

Auction Rate Securities - The Instrument

Auction rate securities is a financial innovation or a security market innovation that seems to be failed one at the moment. We need to understand how it was developed and made to be a sufficiently big market. Then we need to understand what factors led to its failure. The security market intermediaries gained some money from the instrument. But now they are losing some money from it.

We need to understand the security first

What is an Auction Rate Security?
Auction Rate Securities (ARS) are securities with long-term maturities that are structured with the possibility of short-term holding periods, this is attempted by use of a Dutch Auction. A Dutch Auction takes place at the beginning of each holding period, which determines the coupon/dividend. At the end of each holding period, a new Dutch Auction is held, determining the coupon/dividend for the next holding period. Investors can sell, buy (if available) or continue to hold their Auction Rate Security at each auction. The length of each holding period is determined at the time of the security’s original issuance. Typical holding periods are 7, 28 and 35 days.
Overview of Morgan Keegan’s Auction Rate Program
Morgan Keegan’s Auction Rate Program will use long- dated bonds that provide short-term interest rates and liquidity determined through the Dutch Auction process. Morgan Keegan will be using either a 7, 28 or 35-day auction rate period. The coupon/dividend is paid to the ARS holder the day after the 7, 28 or 35-day holding period. The majority of ARS bonds that Morgan Keegan offers have an investment grade underlying rating. An investor looking for competitive tax-free returns may want to consider ARS. Major features of Municipal Auction Rate Securities include:
• Investment grade rating (most, but not all)
• Dividends paid after 7, 28 or 35 days
• Rates reset every 7, 28 or 35 days
There are important distinctions between ARS and short term investments. ARS provide (but do not guarantee) liquidity at par through 7, 28 and 35-day auctions. By contrast, tax-exempt money market funds provide daily liquidity at net asset value. Commercial paper is an unsecured promissory note, and does not offer guaranteed liquidity. Treasury bills are backed by the full faith and credit of the U.S. government and provide ready liquidity.
Objectives of Auction Rate Securities
• Competitive yields versus traditional money market instruments
• Liquidity based on Auction
• Preservation of principal
• No fees or expenses
Principal and Dividend Safety
Bond Insurance
Bond Insurance will guarantee the regularly scheduled payment of interest on the insured bonds on the scheduled interest payment dates and principal at the stated maturity.
If the auction is not successful (failed auction) the issuer is still responsible for paying the bond holder interest. The bond insurer is only responsible for paying interest and principal in case if issuer default. However, not all auction rate securities offered by Morgan Keegan carry insurance and not all insurers are rated the same. Principal will be paid to the investor immediately following the first successful auction, as a secondary market develops, or at the stated maturity.
Auction and Market Liquidity
ARS holders may instruct their advisors to offer their shares for sale at the next 7, 28 or 35-day auction. If there is a lack of buyers for all available shares, then the auction will be postponed (failed auction). All holders will be awarded a tax-free dividend based on current taxable market rates or in cases of a failed rate, until the next successful auction date. The $25,000 share price remains constant, providing a “$1 in, $1 out” feature that means the principal received upon sale will always equal the amount invested, but could change with market demand.
Money Fund Eligibility
ARS are not eligible for sale to Money Market funds subject to rule 2(a)7 governing money fund investment guidelines.
Purchase Facts
Minimum Purchase:
One share minimum, $25,000 per share.
No Load:
There is no load to shares of ARS purchased or sold at auction.
To Purchase at Auction
To buy ARS at auction, advisors and investors should first discuss the lowest acceptable yield level and the possibility of a failed auction. All buy orders must specify:
• The number of shares desired ($25,000 per share)
• The desired yield
Purchases are submitted through Morgan Keegan’s Retail Fixed Income Trading Desk. If the desired rate is accepted at auction, investors will receive either that rate or a higher rate. Settlement is the next business day. If the desired rate is higher than the rate derived through the auction process, the order will not be filled.
Subsequent Auctions
At subsequent auctions, shareholders may submit one of two orders:
• Sell shares
• Hold shares, accepting the new rate established by the auction.
For additional information, please contact your financial advisor for a copy of the Morgan Keegan Auction Rate Securities Practices and Procedures.
Auction Rate Risks
Investors should be aware that investing in auction rate securities involves certain risks that differentiate such securities from money market investment instruments.
• Liquidity Risk — The ability of an investor to dispose of a share of an auction rate security may be largely dependent on the success of the auction.
There is no assurance that any particular auction will be successful, and neither the issuer nor any broker dealer is obligated to take any action to ensure that an auction will be successful. In the absence of successful auctions, there is no assurance that a secondary market for the auction will develop, or if such a market does develop, that shares will trade at or close to par.
• Purchase or sale through Dutch Auction process — A Dutch Auction is a competitive bidding process designed to determine a rate for the next term, such that all sellers sell at par and all buyers buy at par. A Dutch Auction is designed to set the “equilibrium” rate at which supply equals demand.
• The dealer may bid in the auction and the issuer may purchase in the auction.
In general, dividends on shares of municipal auction rate securities are exempt from regular federal income tax, but may be subject to the application of the federal alternative minimum tax.
Municipal bonds used in Morgan Keegan’s Auction Rate Program will provide federal tax exemption on the coupon/dividend payment and can provide state tax exemption. This formula:

1.00 – Federal Tax Rate
will provide an approximate taxable equivalent yield and allows investors to compare tax-exempt yields to taxable yields.
The Tax-Free Advantage
Investors would have to earn considerably more from a taxable investment to achieve the same after-tax income as from tax-free ARS.
The securities and other investment products described herein are: 1) Not insured by the FDIC, 2) Subject to investment risks, including possible loss of principal amount invested, 3) Not deposits or other obligations of, nor guaranteed by Morgan Keegan & Company, Inc., Regions Financial Corporation or any other affiliates.
Copyright © 2008 Morgan Keegan & Co., Inc. All rights reserved. Last posted on Aug 15, 2008
accessed on 17th August 2008


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