If you’re one of the unfortunate investors who recently discovered that your "money market equivalent" securities are frozen and not liquid you’re probably both concerned and upset.

First, a short explanation of why your position is frozen. One of the most common money market equivalents is a bond-like security called an Auction Rate Preferred (ARP) bond. These are actually long term bonds that get auctioned off every few weeks or months. Investors willing to hold their position merely buy them back at the then prevailing interest rate, usually automatically, until the next auction. Those who no longer wish to own the position can allow another bidder to buy their bonds at auction and get their cash back. This all works well until there aren’t enough bidders to buy back all the Auction Rate Preferred bonds. When this happens it becomes a "failed" auction and the owners are forced to hold their bonds for a longer period of time. How long? It depends upon how long it takes new buyers to emerge which could be weeks, months or even longer.

If you’re stuck with failed bonds what does that mean and what should you do? Fortunately most ARPs are sound credits so in most cases it means only that you’ll need to wait out the markets until new buyers emerge. For investors that don’t need the liquidity this is most likely not a big problem as long as the underlying credit remains strong. For others who need the liquidity you may be forced to sell at a loss. If that’s the case I suggest you sell only what you absolutely have to in order to meet your immediate cash needs. Be sure that your broker is aware of your desire to sell and ask him/her to discuss your options for getting out at the best possible price. Most of all don’t panic. Market dislocations such as this do happen and given enough time they almost always pass. The good news is that failed ARPs usually yield considerably more as a result of the failure so you should be getting a better current yield to help offset some of the additional anxiety. Be sure to monitor your positions for potential credit problems and then wait it out as best you can. Avoid selling unless deteriorating credit or a serious need for liquidity forces you to sell.

Owners of Auction Rate Preferreds are re-discovering that incremental return usually carries with it incremental risk. Fortunately the risks for ARP holders are mostly related to a lack of liquidity which should clear over time. Try to be patient, monitor the situation closely and with any luck you should be fine.

Randy Gridley

March, 2008