Auction-Rate Securities: Hold That Gavel

The securities--long-term bonds that act like short-term debt--have often helped treasurers squeeze out added return on corporate cash balances. But a bevy of woes is making it tougher to embrace the cash-management tool.

Earlier this month, software supplier Comverse Technology Inc. changed the classification of nearly $2 billion worth of auction-rate securities to short-term investments. Previously, the bonds had been slotted as cash or cash equivalents, the more common accounting treatment.

Following the same trend, clothing retailer Abercrombie & Fitch Co., Lawson Software Inc., and bookseller Borders Group Inc. retagged $465 million, $354 million, and $118 million worth of ARS, respectively. So did the tiny search engine company GuruNet Corp., which moved its $1 million investment in the bonds into the short-term-investments column.

Since December, when Ernst & Young first began advising clients to make the change, scores of CFOs have altered the accounting treatment for ARS. The new interpretation of two accounting standards is now endorsed by the Financial Accounting Standards Board, the Securities and Exchange Commission, and the Public Company Accounting Oversight Board, as well as all the Big Four auditors. (The reinterpreted standards are FAS No. 95, Statement of Cash Flows, and FAS No. 115, Accounting for Certain Investments in Debt and Equity Securities.)

A current SEC probe of the auctions, in which investigators are reportedly looking into alleged “bid rigging” within the ARS market, doesn’t appear to involve accounting treatment of the securities. But the investigation led some audit clients to reevaluate their investments and later question the accounting treatment, according to an audit manager who preferred not to be identified. After taking another look at the accounting rules, each of the Big Four concluded that a wholesale reinterpretation of the standards was needed, and the audit firms passed the word to their clients.

The accounting change might turn out be the latest crimp in corporate treasurers’ use of what’s long been seen as an effective cash-management tool. The securities are long-term municipal and corporate bonds (usually with 20-year to 30-year maturities) that are priced and traded like short-term debt.

The reason for the resemblance to short-term debt is that ARS interest rates are reset through a Dutch auction. In a Dutch auction, what sets the price is the bid with the lowest yield that would enable all the bonds in a single block to be sold. (A block of bonds is usually worth at least $200,000.) Generally, the auctions are held every 7, 28, or 30 days, which gives finance executives a chance to liquidate their holdings when they need cash.

The allure of the high-quality bonds — they’re often rated AAA — is that they offer a slightly higher-yielding alternative to money-market accounts, commercial paper, and other liquid investments. “The spreads on auction-rate bonds were always a little higher [than other cash-management options], say 4 to 10 basis points, because of the complexity of the product,” notes Jim Anderson, chief investment officer of SVB Asset Management, which manages fixed-income portfolios for corporations.

Corporate bond investors represent roughly half of the $200 billion ARS market, with the remainder consisting of individual investors, notes Lance Pan, director of credit research at Capital Advisors Group (CAG), which manages $5.5 billion worth of corporate cash assets.

Most corporate ARS investors revealed the accounting change in their first-quarter regulatory filings. Many companies also noted that the adjustments were immaterial and therefore have no adverse affect on the company’s financial performance. Some experts say, however, that the impact of the reclassification may have hidden consequences that CFOs have yet to discover, including market-liquidity problems and debt covenant-defaults.

Prop Man

Ordinarily, a change that doesn’t alter a company’s total assets and is little more than a debt-and-credit balancing exercise wouldn’t attract much attention. But the accounting turnabout is also the latest of a number of problems plaguing the 21-year-old ARS market. Not the least of them is the fallout from the ongoing SEC investigation.

Currently, most auctions are run by a single dealer, and seven of the main securities firms that run them have been contacted by the SEC regarding its investigation. When too few bids come in, the dealer typically props up the auction by entering into the process and placing the final, or “clearing,” bid.

The practice of dealer intervention is at the crux of the SEC probe. Although the commission declined to comment on the investigation, people in the market think that investigators are examining dealer practices. By propping up the auction, the dealer winds up on both sides of the transaction, running the auction for the benefit of issuer and setting the price of the bond for the investor, says CAG’s Pan. If that’s perceived as a conflict of interest, regulatory reform could be in the offing.

Indeed, investors and regulators are worry that many auction-rate issues are handled by only one dealer, notes SVB’s Anderson. “Suppose the dealer decides to stop supporting the market,” he says. “The amount of control one firm has over the auctions, the issuers, and the investors is the reason the SEC is investigating the market.”

Regardless of whether the commission orders a market makeover, however, SVB’s Anderson asserts that liquidity issues are surfacing. Based on the huge spreads — between 40 and 50 basis points — that followed the accounting change, he deduces that the demand for the securities declined.

A drop in demand can’t be verified quantitatively because the dealers that run auctions don’t reveal final bid-to-cover ratios (a measure of auction-demand volume), he says. “No one knows how successful the auctions actually are,” adds Anderson. “We know demand is going down because spreads are going up.”

There’s no doubt that the appetite for new issues has slowed. Between 2001 and 2003, the number of new auction-rate bond issues doubled each year, with 425 new issues generating $43.5 billion in proceeds in 2003, according to Thomson Financial. But in 2004, only 431 new bonds raising $44 billion were issued, a measly increase compared with the 100 percent hikes recorded in previous years. So far this year, 73 new issues have been sent to auctions, generating $7 billion.

A pull-out by too many buyers would lead to a drastic supply-and-demand imbalance. In the extreme, it could spawn failed auctions, which are technically defined as ones lacking the demand needed to sell an entire block of bonds. In that case, treasury managers would have no way of cashing in their long-term bonds except at deep discounts. In effect, buyers would be stuck holding 30-year bonds, not the short-term debt they’d sought.

Anderson defines failure more broadly, as the point when a dearth of bidders forces a dealer to “buy the last piece.” There’s no guarantee that dealers will rescue the auction, and Anderson reckons that there may come a day when the dealers will bow out, deciding that they were investing too much capital in the process and receiving too low a return.

To be sure, auction failures are rare. The last one occurred in 2002 after an ARS issue suffered a credit downgrade. Still, the ARS market has never weathered the kind of pressure it currently faces. In fact, corporate portfolio managers such as SVB and CAG are warning clients to think about liquidating their positions and avoiding investment in new ARS in the near term, at least until the effects of the SEC investigation and the accounting adjustment are understood.

Further, some CFOs might not like the look of their employers’ balance sheets after making the accounting change because the alteration reduces cash holdings. Pan speculates that the shift away from cash and cash equivalents may cause some companies to unintentionally break debt covenants tied to cash ratios.

As a result of the cut in cash balances caused by the bookkeeping adjustment, cash totals could drop below a debt covenant’s threshold. If that happened, the company would fall into technical default. Pan says that most lenders would rather help a healthy company work through a technical default than abandon them. Nonetheless, a broken covenant could be worrisome for marginal companies or ones in financial distress.

In any case, the accounting change is just “splitting hairs,” asserts Jack Ciesielski, the publisher of The Analyst’s Accounting Observer, a newsletter for the securities industry. “Any company that defaults over [the ARS accounting issue] is probably already in trouble,” adds Ciesielski.

Undaunted, So Far

Despite the ARS market’s troubles, however, corporate bond investors don’t appear ready to exit it just yet.

For example, with more than $1 billion currently invested in ARS, Comverse Technology is still bullish on them. In January, Comverse reclassified three years’ worth of the securities, with a value of $1.87 billion, as short-term investments. Despite the accounting change, the securities meet the company’s cash-management criteria in terms of liquidity, yield, and risk profile, according to company spokesperson Paul Baker. A balance-sheet reclassification “doesn’t change that,” he says.

Similarly, Edward Wilhelm, CFO of Borders, says that “given our short-term investment policy, ARS provided the best alternative [in terms of] risk/return for us over the last two years.”

Wilhelm hasn’t decided whether Borders will invest in ARS going forward. He says his team is evaluating cash-management strategies now, as the company’s need for short-term investments is seasonal and applies to the first calendar quarter of each year.

Small companies are weighing their ARS options, too. Steve Steinberg, CFO of GuruNet, which has a market capitalization of $12 million, likes ARS because they deliver “small increases in yields” relative to commercial paper. But Steinberg, who has most of the company’s $1 million of short-term investments tied up in ARS, says he hasn’t yet decided whether he will buy new bonds this year.

When executives do get around to making their choices over the next few months, however, the market and regulatory pressures being placed on the ARS industry will likely figure into the cash-management decisions they make. While no one’s predicting a run on the ARS market, smart corporate treasury managers that consider liquidity a prime investment directive will be careful not get stuck holding the bag — especially one that doesn’t mature for the next 30 years.

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