Auction Rate Securities

Auction Rate Securities (“ARS”) are investment vehicles whose interest or dividend rate is periodically reset through a Dutch auction process offering investors an opportunity to buy, hold or sell securities at the time of the auction. Consequently, this process can facilitate shorter term holding periods even though the securities themselves usually have long term maturities (or perpetual as in the case of preferred securities). The issuers range from municipalities in the form of tax-exempt bonds to preferreds issued by closed-end funds.

This page deals specifically with perpetual Auction Rate Preferred Securities typically issued by closed-end funds in order to provide the funds’ leverage. Each share has a $25,000 par value. Auction Rate Securities that are currently offered through Raymond James carry a “AAA” rating since every dollar invested in these securities is backed by at least twice the amount of the underlying closed-end fund assets.

The dividend usually resets every seven days via Dutch Auction with the new yield generally reflecting current market conditions. Rates may differ depending on the underlying assets, market conditions, as well as supply and demand. A Dutch Auction is a bidding process in which the lowest yield becomes the level at which the entire offering is sold.

For those who may not be familiar with the Dutch Auction process, investors bid for a number of shares at a desired dividend rate. Each accepted bid is awarded securities at the Clearing Rate set during the auction. The Clearing Rate is the lowest rate at which there are purchasers willing to buy all auction rate securities offered for sale in the auction. Although bids with the lowest desired rates are filled first, the highest rate at which the last share is filled sets the clearing rate for all shares of that particular security. If the investor’s desired dividend rate is higher than the rate determined by the auction process, the order will not be filled.

Let’s assume there are 100 shares for sale in a given auction. Below are the bids submitted by buyers:

Weekly liquidity, although not guaranteed, is provided through the auction process. At each auction shareholders make a determination as to whether they wish to sell, hold or hold at a certain rate (which may result in shares being sold if the rate is not reached). If all existing holders decide to hold their auction rate securities without specifying the minimum acceptable rate – in other words, no sell orders are submitted to the Auction – the clearing rate will be set equal to the All Hold Rate, which is generally based on a percentage of a reference rate that is materially below the current market rate.

When submitting orders to buy auction rate securities, investors may use Price Talk provided by their financial advisor as a general guideline of where the Auction is likely, but not guaranteed, to clear. Price Talk is a range of rates that represents the good faith judgment of the firm, such as Raymond James, based on prevailing market conditions, general economic conditions and trends, previous clearing rates, the issuer’s financial condition, and other information. Rates may differ depending on the underlying assets and market conditions as well as supply and demand.

Auction Rate Preferred Securities Are Not Cash Equivalents

As mentioned before, Auction Rate Preferred Securities are perpetual securities that reset their rates periodically – usually every 7, 28, 35 or 49 days. Interest rates are set by a Dutch Auction process and investors can normally hold, sell or buy the securities on the auction dates.

Types of Orders

A deadline for submitting orders may exist and may be different from the deadline set by the Auction Agent.

Fees

Broker dealer agreements provide that the broker dealers will receive fees based on the amount of securities placed.

Taxation

Dividends are subject to income tax. Some closed-end funds are tax-advantaged. Certain closed-end funds declare dividends and capital gains which may not be paid until the following January but could be taxable in the year they are declared. The holders of these ARS may be subject to the same tax liability. Investors should consult a tax professional. Non-U.S. investors residing in the U.S. may be subject to a withholding tax on the dividends paid on taxable closed-end funds.

Tax-Free

Income from national MuniPreferred generally is subject to state and local income taxes. Income from MuniPreferred may be subject to the federal alternative minimum tax. All or part of certain dividends, which will be identified in advantage, may be subject to capital gains or other taxes.

Risk Considerations

Failed Auction (liquidity) – Simply put, a failed auction may occur when there are more sellers than buyers. Although historically not a frequent occurrence, current market conditions have seen an unprecented number of failed auctions. In this event, all holders, including those that submitted a sell, must hold securities until the next successful auction which may be for an indeterminate period of time, possibly until maturity or perpetually. The issuer is not obligated to redeem the securities. In the event of a failed auction, the maximum auction rate would apply. Please note: there is no assurance or guarantee that an interested party will step in to support the auction process. These securities are not listed and there is no guarantee that a secondary market will develop.

Maximum Auction Rate – Maximum Auction Rate is specified in each prospectus. In general, these are the guidelines:

• 150% of the AA rated comparable commercial paper.
• 125% of comparable LIBOR (London Interbank Offered Rate) rate – in case of floating rate closed-end funds.

Quality – AAA rated by one or more credit rating agencies. Funds are required by the Investment Company Act of 1940 to maintain preferred asset coverage of no less than 200%. However, the underlying assets are subject to market fluctuations including interest rates, liquidity, credit and evaluation risk. Consequently, the asset coverage may be impacted. If the issuer is unable to maintain the asset coverage, they may redeem the appropriate amount of auction rate preferred securities in order to retain the 200% coverage or be subject to losing the AAA rating.

If you are interested in learning more about auction rate securities and how they can help you meet your personal financial objectives, please contact your Raymond James Financial Advisor.

Disclaimer:

The client should be aware that, as part of its regular course of business, Raymond James may routinely:

(a) place one or more Orders in Auctions generally for its own account, even after obtaining knowledge of some or all of the other Orders, and it may do so in any particular auction;

(b) place Bids on the firm’s behalf or those of others, and may encourage others to place Bids likely to affect the Clearing Rate (including preventing the Clearing Rate from becoming the Maximum Rate) and the allocation of securities being auctioned (including displacing other Prospective Holders).

In addition, under exceptional circumstances Raymond James may:

(a) place one or more bids in auctions generally to prevent a Failed Auction or a Clearing rate the Broker-Dealer believes is not a market rate at the time it makes its Bid, even after obtaining knowledge of some or all of the other Orders, but is not obligated to continue to place such Bids or to bid in any particular Auction;

(b) encourage bidding by others in Auctions generally to prevent a Failed Auction or a Clearing Rate it believes is not a market Rate, even after obtaining knowledge of some or all of the other Orders, and it may do so in any particular Auction.

Money market funds provide daily liquidity at net asset value which they seek to maintain at stable levels. Income from ARS fluctuates with market conditions, and may be more or less than the yields available from other comparable instruments.

This information herein was obtained from sources which we believe reliable, but the accuracy of which cannot be guaranteed. All bonds are subject to price and availability. We may, from time to time, have a position in the securities mentioned and may buy or sell such securities in the course of our regular business. Investors are advised to review alternatives with their Financial Advisor prior to making an investment decision.