What Does Auction Market Preferred Stock Mean?

Auction market preferred stock refers to preferred equity securities that have interest rates or dividends that are periodically reset through Dutch auctions. Auction market preferred stock typically reset their dividends every 7, 14, 28, or 35 days and are generally structured as preferred shares (issued by closed-end funds). Auction market preferred stock is also known as auction rate preferred stock.

Understanding Auction Market Preferred Stock (AMPS)

Municipalities, public authorities, student loan providers and other institutional borrowers first issued auction-rate securities to raise funds in the 1980s. Auction-rate securities were marketed to retail investors who were seeking a “cash-equivalent” investment that paid a higher yield than money market mutual funds or certificates of deposit, although they did not have the same level of liquidity as those other instruments.

Traditionally, auction rate securities become short-term investment vehicles, because auctions are held so frequently. The benefit for investors has always been that they are holding a relatively liquid security that can be bought and sold rather seamlessly. In a liquid investment, buyers and sellers of a security are not hard to find.

Another benefit to investors is that they essentially are investing in a short-term security because they have the option to sell so frequently, but they typically earn interest rates that exceed other short-term investments. This is because, although auction rate securities are technically issued as long-term contracts, they are liquid investments that can change hands at auctions before the contract expires. Investors in auction rate securities are mainly institutional investors and wealthy individuals.

The auction market preferred stock can be a beneficial investment for larger investors. The auction process will most likely reveal the current market yield for less-risky asset classes, such as preferred stock, and will self-adjust for the effects of alternative investments and inflation.

Auction Market Preferred Stock During the 2008 Financial Crisis

Interest-rate auctions for auction-rate securities began to fail during the 2008 financial crisis. The auctions attracted too few bidders to establish a clearing rate, and these dislocations resulted in high or “penalty” interest rates on those securities and/or an inability of investors to sell their auction-rate securities. The auction-rate securities market collapsed in February 2008 when lead underwriters chose not to step in to support the auctions. For investors, this meant that they were left with illiquid investments.

Since the collapse of the auction-rate securities market, the U.S. Securities and Exchange Commission, Financial Investment Regulatory Authority and state attorneys general have reached settlements with major broker-dealers and other entities. These settlements included agreements to buy back auction-rate securities from certain investors.