Most auction-rate securities were valued at par by their holders until February 2008, when auctions began to fail.
Auction-rate securities are fixed-income securities – either long bonds or preferred shares, with floating interest rates (after auction failure, typically Libor or T-bill floaters). A failed auction-rate securities position generally becomes a highly illiquid, long-term, floating-rate bond (or preferred). Maturities may be either non-existent or as long as 30-50 years.
Typically, such securities are valued with discounted cash-flow models, based on yield spreads, and with quotes from the market. Pluris Valuation Advisors uses two main methods for valuing client ARS positions:
- Discounted cash-flow method
- Secondary market indications method
For more information on our ARS valuation services, or to receive a sample ARS valuation report, please contact us.
Discounted Cash-Flow Method
A discounted cash-flow valuation of auction-rate securities is complicated because both the key inputs to the model, future cash flows and the discount rate, are hard to estimate.
Future cash flows depend on maximum, or fail, rates that “float,” sometimes based on more than a single reference rate. Future cash flows are further complicated by the uncertain prospects for redemption of the securities. Also, while there is academic research on illiquidity spread for corporate bonds, there is very little research on bonds with illiquidity that is comparable in severity to what is being experienced in many parts of the ARS market. In addition, the complexity and opacity of many of these investments call for higher than normal market yields. The weighting of the discounted cash-flow indications, relative to the secondary market indications, depends on the activity level of the particular security in the secondary market.
SLARs, in particular, have highly complex structures with difficult-to-estimate fail rates and hard-to-understand portfolios backing the securities. For example, the level of collateralization varies from trust to trust, as does the ability of a given trust to continue paying the penalty rates to its ARS holders. In addition, the effective (as opposed to the legal) maturity of the SLARs may differ widely from tranche to tranche within a trust. ARPS, on the other hand, have no maturity but may be subject to redemption within relatively short time horizons, especially for taxable ARPS. MARS have widely different terms and are subject to credit risks that also vary widely by issuer.
Secondary Market Indications
Pluris has exclusive, direct access to trading data from the deepest, most active secondary market for auction-rate securities: SecondMarket. All ARSs with failed auctions tend to trade at a discount. The failure of the auctions suggests that the market-clearing yield for the securities is higher than the current and future interest rate on the bond. Bonds that pay interest below the market rate always trade at a discount.
For entities that are required to report the “fair value” of their investments, ASC 820 (FAS 157) controls valuations. The clear intention of the FASB in formulating the principles underlying ASC 820 (FAS 157) was to move fair value measurements, as far as possible, away from mark-to-model and toward mark-to-market, except in cases where all the market evidence available is from “forced or distressed” sales. During the first four months of the existence of the secondary ARS market, more than 300 transactions have taken place, with little or no evidence suggesting that a substantial portion of the sales were forced sales. Input from the secondary market is critical in valuing auction-rate securities and such evidence should never be disregarded.
In keeping with the significant variation between the segments of the ARS market, we can discern trends in how auction-rate securities are priced. However, the average discounts are changing rapidly and, also, vary widely from instrument to instrument. MARS discounts show great dispersion in the market but trade closer to par, on average, than other types of ARS, while ARPS trade at discounts that primarily reflect the market’s perception of the time to redemption of the issuing fund. SLARSs trade at much deeper discounts, and bids for CDOs or monoline-backed ARSs may be at discounts of 50 percent or more.
For more information on our ARS valuation services, or to receive a sample ARS valuation report, please contact us.
