Variable Rate vs. Auction Rate

Auction Rate Preferred’s
Many individuals and corporations use Auction Rate Preferred’s (ARP’s) instead of money market funds. These securities are typically viewed by most investors as a money market substitute, but there are some important characteristics that make them different from a true money market instrument. In fact, these securities are not money market eligible securities for money market funds.

Most money market funds invest in Variable Rate Demand Notes. These trade in $100,000 denominations. The rates normally reset weekly by the service provider who is the dealer that has the floating rate securities. The investor has the option of putting back these floaters to the dealer by giving 1 week’s notice. The security is normally credit enhanced by either an insurer or a bank. The liquidity (ability to put back the security) is normally guaranteed by a bank. These VRDN’s are bought and sold at par (100).

An auction rate security is reset by an auction process. The dealer does not set the rate on the security. It is possible (but highly unlikely) that there could be a failed auction. In the event of a failed auction, the investor would own the security to whatever the stated maturity might be. It is this possibility that makes ARP’s ineligible for money market funds.

VRDN’s are normally sold by institutional sales people who trade them in large size. ARP’s are normally sold by middle market and retail sales people in smaller-sized pieces than VRDN’s. The sales credits paid to market ARP’s tend to be higher than those for VRDN’s. This helps to explain why the yields on the Auction Rate products have tended to be lower than those for Variable Rate securities. This is shown in the chart below. The average spread has been about 4 bp’s in extra yield for the VRDN’s. Recently, this situation has changed. This change and the absolute level of rates is shown in the table below. ARP’s are now yielding about 80 bp’s more than VRDN’s. We believe there are 2 reasons for this change in the spread. First, there is a high degree of uncertainty in the money market at the present time. Investors are attempting to reduce risk in all their money market holdings. They are now realizing there is “auction” risk and are commanding more of a premium for holding


ARP’s. Secondly, many corporations desire to reduce their holdings of ARP’s over year end, because they are treated as longer maturity investments on their books. This has resulted in dealers carrying unusually high amounts of these securities coming into year-end.

Conclusion
We would expect many of these corporations to repurchase the ARP’s they have sold after the first of the year. However, we would expect the spread between these two short-term instruments to be greater for the ARP’s than VRDN’s into the foreseeable future.