What Is An Auction Rate Bond (ARB)?

An auction rate bond (ARB), also known as an auction rate security (ARS), is debt security with an adjustable interest rate. The maturities are fixed-terms of 20 to 30 years. The interest rate is reset regularly. Non-profit institutions and municipalities utilize ARBs as a means to reduce borrowing costs for long-term financing.

An auction rate bond sells at interest rates that clear the market at the lowest possible yield. This process ensures all bidders receive the same return on the bond. Since 2008, the demand for these bonds has become illiquid.

The Basics Of An Auction Rate Bond

Many investors invested in auction rate bonds due to their high investment grade rating, their tax-exempt status, and their cash-equivalent status. However, they no longer trade. In most cases, they are exempt from federal, state and local taxes. The ARB has a slightly higher after-tax yield than a money market and certificate of deposits (CD) because of their increased risk and complex nature. Also, auction rate bonds are not as liquid as money market funds, and CDs so may be harder to trade. 

An auction rate bond has an interest rate determined through a modified Dutch auction. A Dutch auction is a public offering auction structure in which the setting price of the offering is complete after accepting all bids. This method allows the determination of the highest rate and the lowest yield at which the total offering can sell. In this type of auction, investors place a bid for the amount they are willing to buy and the yield they expect to receive.

According to the Securities and Exchange Commission (SEC), auction rate bonds, or securities, periodically re-set their interest rates every 7, 14, 28, or 35 days. Student loan providers, municipalities, public authorities, and institutional borrowers use ARBs. Following the financial crisis of 2007-08, few auctions have been held, and the market has become illiquid. The Financial Industry Regulatory Authority (FINRA), SEC, and state attorneys generals reached an agreement with the significant sellers of these investments. Most large brokers have repurchased or replaced the ARBs.

The medium to long-term bond ARB acts similarly to a shorter term bond, as the schedule of the bond is reset on a set schedule. A Dutch auction structure functions by setting the price after taking bids allowing for the highest offering available.

Key Takeaways

  • An Auction Rate Bond (ARB) is a 20-30 year bond with adjustable interest rates set by a market auction.
  • ARBs are sold through a Dutch auction where the bond is sold at an interest rate that will clear the market at the lowest yield possible. 
  • Auctions for ARBs are held every 7, 28, or 35 days, at which time the rates are reset. 
  • Many municipal bonds as well as the U.S. Treasury uses a Dutch auction structure to sell its securities.

Example Of Dutch Auctions And ARBs

If you were interested in investing in a company that made an initial public offering (IPO) using a Dutch auction model, you would submit a bid to the company along with all the other interested investors. The bid would include the number shares and the price you are willing to pay for them. You may choose to enter your bid for 50 shares at $200 a share, whereas another investor could submit a bid of 200 shares at $190 per share.

The company collects the bids from all interested parties and then sets the price for all the shares at the cost of the lowest accepted bid. This method means that if they took the proposal of the investor offering $190 per share, though they purchase 200 and you only purchase 50 shares you will still pay $190 per share.

The U.S. Treasury uses a Dutch auction structure to sell its securities. Though ARBs use a similar structure, when an auction fails due to a lack of buyers, it impacts both bondholders and bond issuers negatively. The bondholders can't sell what is supposed to be a liquid investment and issuers are forced to pay higher default rates.