Auction Rate Security (ARS)

What Is an Auction Rate Security (ARS)?

An auction rate security (ARS) is a type of variable-rate debt security that is sold through a Dutch auction. An ARS is generally either a bond with a long-term maturity of 20 to 30 years or preferred shares of stock issued by a closed-end fund. The ARS is sold at an interest rate that will clear the market at the lowest yield conceivable. This guarantees that all bidders on an ARS receive a similar yield on the debt issue. The interest rate on an ARS is reset periodically through extra auctions, regularly every seven, 14, 28, or 35 days.

During the global financial crisis of 2008, the ARS market failed when the auctions couldn't attract an adequate number of bidders to lay out a clearing rate. This implied numerous investors were left holding investments with long-term maturities they couldn't sell.

$330 billion

The estimated amount of money invested in auction rate securities before the market collapsed in 2008.

Understanding Auction Rate Securities (ARS)

Municipal and corporate issuers seeking to raise debt for a minimal price and searching 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. As it were, an ARS acts as though it were a more limited term issue since interest rates are reset roughly consistently. 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.

Before the ARS Auction

Auctions for ARS are held each seven, 14, 28, or 35 days, when the rates are reset. Prior to the auction, brokers talk about the scope of potential ARS rates with their clients. This discussion, alluded to as "price talk", gives clients a basis for probable rates, however investors are free to submit bids outside of this reach.

Investors enter a competitive bidding process by submitting bids that determine the number of shares, in divisions of $25,000, that they will purchase and the lowest interest rate that they might want to acknowledge from the bond.

Bids are accepted until the cutoff time after which the auction agent works out the clearing rate in view of the submitted bids. The clearing rate is the interest rate that will be paid on the securities until the next auction.

After the ARS Auction

On the off chance that the investor's bid rate is not exactly the clearing rate, the investor will receive all or a part of their ideal bid. Bids placed over the clearing rate won't be filled. Coupons are paid soon after each auction period ends and the yield is settled each quarter. Investors are drawn to these securities due to high investment-grade ratings notwithstanding the fact that they are exempt from federal, state, and neighborhood taxes. ARS likewise gives a somewhat higher after-tax yield than money market instruments due to their complexity and increase in risk.

The Collapse of the ARS Market

In Feb. 2008, the ARS market failed when the four fundamental investment banks in the market — Citigroup, UBS AG, Wachovia, and Merrill Lynch — declined to act as bidders of last resort due to liquidity concerns. Brokers who sold these securities in the interest of issuers persuaded buyers to think they were liquid.

At the point when the downside of ARS became known, the auctions attracted too couple of bidders to lay out a clearing rate, bringing about the powerlessness of ARS holders to sell their long-term investments which had turned illiquid. In effect, a market available to be purchased rate securities has failed to exist.

After the collapse of the ARS market, the Financial Industry Regulatory Authority (FINRA), the Securities and Exchange Commission (SEC), and state lawyers general stepped in to arrange settlements with major specialist sellers for the benefit of investors. Large financial foundations — including Bank of America and Citigroup — were requested to pay back more than $40 billion to investors who said the organizations had not completely disclosed to them the risks of ARS investments.

Highlights

• The ARS market collapsed during the global financial crisis of 2008, leaving a huge number of investors holding long-term investments they couldn't sell.
• An auction rate security (ARS) is a type of variable-rate investment that is generally either a bond with a long-term maturity or preferred shares of stock.
• The interest rate on an ARS regularly resets each seven, 14, 28, or 35 days through a Dutch auction.
• A Dutch auction is a public auction wherein investors place bids for the amount of the offering they will buy and the price they will pay.