Auction rate securities (ARSs) are usually intermediate to long-term debt instruments with variable interest rates that are reset periodically through an auction. ARSs can come in the form of municipal bonds, corporate bonds, or even preferred stock (when its dividend is set through an auction). Typical ARS issuers include municipalities and student loan providers. The yields are reset regularly through auctions and are linked to short-term interest rates. Let's take a look at why investors may be interested in bidding on these securities. (To get background info on these types of investments, check out our Advanced Bond Concepts tutorial.)

And the Winner Is … the Lowest Bidder?
Shares of auction rate securities are traded through a Dutch auction. Investors wishing to purchase securities must submit bids to their brokers; each bid specifies the number of shares the investor wishes to purchase and the lowest interest rate the investor is willing to accept from the bond. (To keep reading on this, see What does it mean when my broker says that shares are for auction?)

Prior to the auction, brokers discuss the range of possible ARS rates with their clients. This discussion, referred to as "price talk", gives clients a basis for probable rates, but investors are free to submit bids outside of this range.

Each auction is supervised by an auction agent and has a deadline for order submission. Upon reviewing the bids, the auction agent calculates the clearing rate. The clearing rate is the interest rate that will be paid on the securities until the next auction.

If the clearing rate is above the rate submitted by a potential investor, the investor will receive all, or at least part of, his or her desired bid.

Trading Auction Rate Securities
Auctions occur fairly often, allowing rates to be reset every 7, 14, 28 or 35 days. Each security has a set number of shares available. The types of orders that can be placed will depend on whether the investor is an existing ARS owner or a potential investor.

Existing owners can choose to hold, sell or buy more of the ARS.

  • Hold orders indicate that the owner will keep securities regardless of the clearing rate.
    • Deemed hold orders are automatically placed for existing owners who take no action before the auction deadline. This allows the owners to maintain their existing positions.
    • Hold at rate orders are placed by owners who wish to keep the securities only if the clearing rate is at or above a specific rate chosen by the owner.
  • Sell orders are used by existing owners who wish to sell the securities regardless of the clearing rate.
  • Buy orders can be submitted by existing owners and potential investors. A buy order indicates the investor wishes to purchase securities if the clearing rate is at or above the rate specified within the bid.

Aside from retail investors, broker-dealers can submit orders in auctions for their own accounts.

Considerations for Retail Investors
Auction rate securities provide investors with a variable-rate investment. The rates paid by auction rate securities are generally higher than those offered by certificates of deposit or money market accounts and the securities are typically insured. In this sense, a long-term debt issue can behave like a short-term issue because of the frequency of rate resetting auctions. The frequency of auctions can also afford investors the opportunity to take advantage of rising interest rates.

Even though the frequency of rate resetting auctions has kept the ARS market liquid, investors should not forget that these securities have long-term maturities. If an auction is unable to generate enough buyers, existing owners could be stuck with illiquid assets until the maturity date.

When the Market Fails
Each ARS issue has a maximum rate that the issuer must pay in the event that all shares are not sold. When auction agents do not receive enough orders to purchase all of the securities available for sale below the maximum rate, this is referred to as a failed auction.

In a failed auction, the inability to find buyers forces issuers to pay high rates and prohibits existing owners from liquidating their positions.

In early 2008, the infamous credit crunch brought about by the subprime mortgage fallout led to the failure of the ARS market. Retail investors withdrew from the market, and the four major investment banks in the ARS market refused to submit bids for their own broker-dealer accounts. (To read more about the credit crunch, see our Subprime Mortgages feature.)

As a result, many investors were left with illiquid, long-term securities, many of which lost a substantial portion of their value. In the months following the ARS market failure, several investment banks faced investigations for marketing ARSs to investors as a safe alternative to cash. The investigations led to a wave of settlements in which the banks agreed to buy back many of the securities in question.

While auction rate securities may have been marketed and sold as cash alternatives, they are truly long-term debt instruments with variable interest rates.

Rates paid on ARSs are linked to short-term interest rates and are reset periodically through auctions. The success of each auction depends on interest rates, as well as the balance of supply and demand between existing owners and potential buyers.

Auction rate securities come with different terms and risks, both of which should be explored prior to entering the market.