Four Alternatives to Failed ARS Auctions

Editor's note: This is a special investor alert from FINRA -- Financial Industry Regulatory Authority. It has been republished for TheStreet.com readers.

Auction rate securities (ARS) refer to long-term investments that have a short-term twist: the interest rates or dividends they pay are reset at frequent intervals through auctions, which typically occur every 7, 14, 28, or 35 days. Usually, these auctions also provide the primary source of liquidity to ARS investors who wish to sell their investment.

Recent developments in the credit market have led many of the ARS auctions to fail, which may prevent existing investors from selling their ARS holdings. As a result, ARS investors who treated these securities as a ready source of cash are finding themselves short on readily available funds. In response, some issuers of ARS have announced redemptions of shares, generally at par value . In some cases, however, the issuer only offers to redeem some but not all of the outstanding shares. This may leave some investors with holdings they are unable to liquidate .

Loss of liquidity does not mean that you cannot ever get your money back. But, if you need money in a hurry, any illiquid investment can be a financial hardship. We are publishing this Alert to let investors know about some of the options available to them in the event their ARS investment becomes illiquid. We also want investors to understand what can happen when an issuer makes a call for a partial redemption.

What are ARS?

Investors who purchase ARS are typically seeking a cash-like investment that pays a higher yield than money market mutual funds or certificates of deposit. There generally are two types of ARS, bonds with long-term maturities (20 to 30 years) and preferred shares with a cash dividend. Both the interest on the bonds and the dividend on the preferred shares are variable based on rates that are set through auctions for a specified short term usually measured in days -- 7, 14, 28, or 35. This is unlike a traditional bond that is issued with an interest rate set for the life of the bond or preferred stock that specifies the dividend rate for the life of the shares. Auction rate bonds are issued by municipalities, student-loan authorities, museums and many others. Some auction rate bonds, such as those issued by municipalities, may offer certain tax advantages. Auction rate preferred shares are issued by closed-end funds.

How can ARS become illiquid?

Liquidity issues arise when an auction fails. To understand how an auction can fail, it helps to know how ARS auctions work. Before each auction, current ARS investors can request either to sell their ARS, to hold their existing position at a specified interest or dividend rate, or to hold at whatever new interest rate or dividend the auction establishes. The size of any given auction will depend on how many current ARS investors want to sell and how many want to hold at a certain minimum rate.

Potential purchasers then indicate how much they wish to buy and what interest rate or dividend they are willing to accept. Bids, or buy orders, with the lowest interest or dividend rates get accepted first, followed by successively higher bids until all the securities available for auction are sold. The highest rate accepted in the auction -- the "clearing rate"-- then becomes the interest or dividend rate that applies to all the ARS until the next auction.

ARS auctions can fail when supply exceeds demand -- in other words, when there are not enough bids to purchase all the securities offered for sale in the auction. When an ARS auction fails, current investors will continue to hold their securities and will generally receive an interest rate or dividend set above market rates for the next holding period-up to any maximum disclosed in the offering documents.

Unfortunately, due to recent developments in the credit market -- including downgrades in the credit ratings of bond issuers and bond insurers -- a significant number of auctions have failed, leaving some investors who counted on immediate access to their funds wondering about their options.

What alternatives are available?

ARS investors should read the offering documents carefully to determine what, if any, provisions the issuer has made in anticipation of illiquidity and failed auctions. Some issuers of bonds or preferred shares may have reserved the right to convert the ARS into a fixed or variable rate security or to call the instrument at a certain price.

ARS investors who want to liquidate their holdings -- but cannot because of failed auctions -- have a variety of options. These include:

1. Continuing to Hold
2. Borrowing on Margin
3. Liquidating Other Investments
4. Selling in the Secondary Market

Continuing to Hold: If you have no need to access the monies invested in the ARS, you may want to consider whether that above-market rate is enough for you to continue holding until the next auction, which generally will be less than a month away. There is, of course, a chance that subsequent auctions will fail as well. As noted above, the issuer may be authorized to call the instrument or convert it into a fixed or variable rate security.