Auction Rate Securities - Not a Better Money Market
How would you like to invest in a product that returns high single digit returns that’s as safe as cash or a money market? They’re called auction rate securities and they’ve been marketed as just that. The only problem is, as investors are now finding out, these things are anything but a cash equivalent. Here’s the deal.
An auction rate security is a debt instrument (usually a bond but can be preferred stock) that has its interest rate reset, usually once a week or month, through an auction.
The idea is that an investor will get a better rate of return than in a money market or savings account since they’re investing in actual corporate or municipal debt instruments. The problem, as this Reuters article points out, is that when there’s a flight to quality in bonds, as there is now, there’s no market for the auction. In other words, nobody shows up to bid on the auction rates. Result? People have lost significant portions of their investment.
It’s clear, then, that auction rate securities are not a juiced substitute for cash equivalents. Now that formerly-high yield savings accounts and money market funds are paying such low interest rates, I fear more people will get suckered into these things. It’s a great example of the old saw “if it sounds too good to be true, it is.”
April 2nd, 2008 at 2:54 pm
Who’s missing from the litigation list? Goldman Sachs, which clearly spells out the risk to auction rate securities in its disclosure to investors.
To be fair, until the last couple of months, auctions have never failed.
And also to be fair in distributing blame, investors need to be skeptical of their brokers and never invest in instruments they don’t understand. Did any of the investors who got burned understand what ARS are before they got burned? Not likely.
April 2nd, 2008 at 5:43 pm
April 2nd, 2008 at 6:03 pm
April 3rd, 2008 at 6:17 am
@ Lily - I actually tend to think that some of the investors did, in fact, understand what ARSs were. But, as you point out, the auction had never failed so they believed they were getting a great deal.
April 4th, 2008 at 11:02 am
I honestly think that half of the brokers pushing these didn’t understand the true risk (or at least did not give it an objective analysis).
To make things worse, many firms do not pay their brokers anything for client assets sitting in money markets… So there is an incentive, even if it is 15-25bp, to push them towards the APS.
Ken Clark, CFP
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