DEFINITION of Auction Rate Security - ARS

An auction rate security (ARS) is a debt security that is sold through a Dutch auction. The auction rate security is sold at an interest rate that will clear the market at the lowest yield possible. This ensures that all bidders on an ARS receive the same yield on the debt issue.

The interest rate on an ARS is reset periodically during each auction.

BREAKING DOWN Auction Rate Security - ARS

Municipal and corporate issuers seeking to raise debt at a low cost and looking for the flexibility of variable rates can go the route of auction rate securities (ARS). Auction rate securities are medium- to long-term debt issues which have their interest rates determined through a Dutch auction process. ARS, in a way, acts as if it were a shorter-term issue since interest rates are reset approximately every month. A Dutch auction is a public offering auction structure in which the price of the offering is set after taking in all bids and determining the highest price at which the total offering can be sold.

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. Investors enter a competitive bidding process by submitting bids which specify the number of shares, in denominations of $25,000, that they are willing to purchase and the lowest interest rate that they would be willing to accept from the bond. Bids are accepted until the deadline after which the auction agent calculates the clearing rate based on the submitted bids. The clearing rate is the interest rate that will be paid on the securities until the next auction. If the investor’s bid rate is less than the clearing rate, the investor will receive all or a part of his or her desired bid. Bids placed above the clearing rate will not be filled.

Auctions for ARS are held every 7, 28, or 35 days, at which time the rates are reset. Coupons are paid either shortly after each auction period ends and the yield is settled or every quarter. Investors are drawn to these securities due to high investment grade rating in addition to the fact that they are exempt form federal, state, and local taxes. ARS also provides a slightly higher after-tax yield than money market instruments due to their complexity with an increase in risk.

In 2008, the ARS auction market failed when the four main investment banks in the market - Citigroup, UBS AG, Morgan Stanley, and Merrill Lynch - declined to act as bidders of last resort as they usually did due to liquidity concerns. Brokers who sold these securities on behalf of issuers led buyers to believe they were liquid. When the downside of ARS came to light, the auctions attracted too few bidders to establish a clearing rate, resulting in the inability of ARS holders to sell their long-term investments which had turned illiquid. In effect, a market for auction rate securities has ceased to exist.