What is an Auction Rate
Auction rate is the interest rate that will be paid on a specific security as determined by the Dutch auction process. The auctions take place at intervals, and the interest rate is fixed until the next auction occurs. This process helps determine the interest rate on Treasury securities.
BREAKING DOWN Auction Rate
The auction rate is also used in other debt securities, such as municipal bonds. This is a good way for both the investor and the issuer to forecast their returns and costs, respectively, as the auctions can be held as often as annually or even weekly. The auction process also allows investors to mitigate reinvestment risk because the 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 a bid for the amount they are willing to buy in terms of quantity and price. The competitive bids placed by direct bidders in the auction of Treasury securities, which set the yield or auction rate that all auction participants eventually receive, is an example of the Dutch auction process.
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 than raising funds through a syndicate of third party banks and 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 and price it based on estimated buyer demand.
Investment banks serve the function of ensuring prospective investors understand the business and competitive landscape of a company going public in an initial public offering or the fundamentals and credit quality of an issuer considering a fixed income offering. Through this due diligence, 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.