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 security 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.
