Auction Rate

What Is Auction Rate?

Auction rate is the interest rate that will be paid on a specific security as determined by a Dutch auction process.

Understanding Auction Rate

Dutch auctions take place at intervals, and the interest rate is fixed until the next auction occurs. The U.S. Treasury runs auctions to help determine the interest rate on Treasury securities.

Dutch auctions are a good way for both investor and issuer to forecast returns and costs, respectively, as auctions can be run annually or as often as weekly. The auction process also allows investors to mitigate reinvestment risk because interest rate fluctuations are generally less volatile.

A Dutch auction is a public offering auction structure, in which the price of the offering is set after taking in all bids to determine the highest price at which the total offering can be sold. In this type of auction, investors place bids for the quantities they are willing to buy and the price they are willing to pay.

An example of the Dutch auction process would be the competitive bids placed in the auction of Treasury securities, which set the yield or auction rate that all participants eventually receive.

Auction rate securities are long-term variable rate bonds sold through a Dutch auction. They are tied to short-term interest rates and available as both taxable and tax-exempt bonds. Auction rate securities provide benefits to both the bond issuer and investor. Issuers can secure lower-cost financing compared with raising funds through a syndicate of third party banks. In addition, the financing process is simpler and more straightforward for investors participating in the auction.

Limitations to Auction Rate Bidding

A Dutch auction fails when there are insufficient investors willing to buy the securities up for bid. Examples include when banks and other financial institutions backed out of the market for auction rate securities in early 2008.

This demonstrates the risks of an auction process for a new securities offering compared to the traditional process of relying on third-party agents, most often investment banks, to market the offering. Investment banks serve the function of ensuring prospective investors understand the business and competitive landscape of a company conducting an initial public offering, or the fundamentals and credit quality of an issuer considering a fixed income offering.

Through this due diligence process, bankers can gauge what investors are willing to pay and assess whether there is enough demand for the offering to be successful. In an auction, meanwhile, issuers have no assurance that any bidders will show up.