Auction Rate Security

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An Auction Rate Security (ARS) typically refers to a debt instrument (corporate or municipal bonds) with a long-term nominal maturity for which the interest rate is reset through a dutch auction. It could also refer to a preferred stock for which the dividend is reset through the same process. In a dutch auction, a broker-dealer submits bids, on behalf of current and prospective investors, to the auction agent. Based on the submitted bids, the auction agent will set the next interest rate by determining the lowest rate to clear the total outstanding amount of ARS. ARS holders do not have the right to put their securities back to the issuer; as a result no bank liquidity facility is required.

Auctions are typically held every 7, 28, or 35 days; interest on these securities is paid at the end of each auction period. Certain types of ARS auction daily, with coupon being paid on the first of every month. There are also other, more unusual, reset periods, including 14 day, 49 days, 91 days, semi-annual and annual. Non-daily ARS settle on the next business day, daily ARS settle the same day.

As bank liquidity has become more expensive, the auction market has become increasingly attractive to issuers seeking the low cost and flexibility of variable rate debt.

The first auction rate securit for the tax-exempt market was introduced by Goldman Sachs in 1988.^[1] Today the market for ARS has grown to over $200 billion, with roughly half of it being composed of corporate issues.^[2] Because of their complexity and the minimum denomination of $25,000 or more, most holders of auction rate securities are institutional investors and high net worth individuals.

Some negative aspects of ARS include lower liquidity and potential drops in the coupon rate.

1 Auction Rate Securities Overview
2 Pros and Cons of Auction Rate Securities
3 See Also
4 References

[edit] Auction Rate Securities Overview

The interest rate on ARS is determinded through a Dutch auction process. The total number of shares available to auction at any given period is determined by the number of existing bond holders who wish to sell or hold bonds only at a minimum yield.

Existing holders and potential investors enter a competitive bidding process through broker/dealer(s). Buyers specify the number of shares, typically in denominations of $25,000, they wish to purchase with the lowest interest rate they are willing to accept.

Each bid and order size is ranked from lowest to highest minimum bid rate. The lowest bid rate at which all the shares can be sold at par establishes the interest rate, otherwise known as the “clearing rate”. This rate is paid on the entire issue for the upcoming period. Investors who bid a minimum rate above the clearing rate receive no bonds, while those whose minimum bid rates were at or below the clearing rate receive the clearing rate for the next period.

[edit] Price Talk

Before the day's auction starts, broker-dealers will typically provide "price talk" to their clients which includes a range of likely clearing rates for that auction. The price talk is based on a number of factors including the issuer's credit rating, reset period of the ARS, and the last clearence rate for this and other similar issues. It might also take into account general macroeconomic events, such as announcements by the Federal Reserve Board of a change in the federal funds rate. Clients, however, are not required to bid within the price talk range.

[edit] Types of ARS Orders

Hold - Hold an existing position regardless of the new interest rate (these shares are not included in auction).

Hold at Rate - Bid to hold an existing position at a specified minimum rate. If the rate clearence rate is below the bid to hold rate, the securities are sold.

Sell - Sell an existing position regardless of the interest rate set at the auction.

Buy - Submit a bid to buy a new position at a specified minimum interest rate (new buyers or existing holders adding to their position at a specified interest rate).

[edit] All-Hold Auction

If all current holders decide to hold their securities without specifying a minimum rate, the auction is called an "All Hold" auction and the new rate will be set to the "All Hold Rate" defined in the offering documents for the issue. The All Hold Rate typically is based on a percentage of a reference rate, usually the London Interbank Offered Rate (LIBOR), the Bond Market Association (TBMA) index, or an index of Treasury security. This rate is usually significantly below the market rate.

[edit] Failed Auction

If there are not enough orders to purchase all the shares being sold at the auction, a failed auction occurs. In this scenario, the rate is set to the maximum rate defined for the issuer (typically a multiple of LIBOR or the TBMA index). The purpose of the higher rate is to compensate the holders who have not been able to sell their positions. Broker-dealers usually bid on their own behalf to prevent failed auctions from happening. This makes failed auctions extremelly rare, although they could occur under certain conditions such as a decline in the issuers credit quality or a disruption in the market.

[edit] Secondary Market for ARS

Although not onbligated to do so, many broker-dealers provide a secondary market for auction rate securities between auctions. If such a market develops, securities can be traded between interested clients at par value with accrued interest.

[edit] Pros and Cons of Auction Rate Securities

For issuers, ARS offer low financing cost, in some cases more attractive than traditional variable rate debt obligations (VDROs). No third-party bank support is required, and there are typically fewer parties to the financing process. ARS eliminates renewal risk and the risk of increased fees. There is no exposure to bank rating downgrades, and ARS offer the same flexibility found in traditional VRDOs.

For buyers, ARS provide a slightly higher after tax yield than money market instruments due to their complexity. Most securities are AAA rated as well as federal, state and local tax exempt. They also provide an opportunity to diversify one's cash equivalent holdings.