Understanding Auction Rate Securities (ARS): A Comprehensive Guide

What Are Auction Rate Securities (ARS)?

An auction rate security (ARS) is a long-term investment whose interest rate is set through regular auctions. These securities are issued as bonds or preferred stock, and their rates change based on bids submitted by investors in a Dutch auction. During the auction, investors state the interest rate they’re willing to accept, and one rate is chosen that applies to all successful bidders. The rate is then reset regularly, often every seven, 28, or 35 days.

How Do Auction Rate Securities (ARS) Work?

Municipal and corporate issuers seeking to raise debt at a low cost and looking 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. In a way, an ARS acts as if it were a shorter-term issue since interest rates are reset approximately every month. 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.

Preparations Before the ARS Auction

Auctions for ARS are held every seven, 14, 28, or 35 days, at which time the rates are reset. Prior to the auction, brokers discuss the range of possible ARS rates with their clients. This discussion, referred to as “price talk”, gives clients a basis for probable rates, but investors are free to submit bids outside of this range.

Investors enter a competitive bidding process by submitting bids that specify the number of shares, in denominations of $25,000, that they are willing to purchase and the lowest interest rate that they would be willing to accept from the bond.

Bids are accepted until the deadline after which the auction agent calculates the clearing rate based on the submitted bids. The clearing rate is the interest rate that will be paid on the securities until the next auction.

Post-Auction Outcomes for ARS

If the investor’s bid rate is less than the clearing rate, the investor will receive all or a part of their desired bid. Bids placed above the clearing rate will not be filled. Coupons are paid shortly after each auction period ends and the yield is settled every quarter. Investors are drawn to these securities due to high investment-grade ratings in addition to the fact that they are exempt from federal, state, and local taxes. ARS also provides a slightly higher after-tax yield than money market instruments due to their complexity and increase in risk.

Unraveling the ARS Market Collapse

In Feb. 2008, the ARS market failed when the four main 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 on behalf of issuers led buyers to believe they were liquid.

When the downside of ARS came to light, the auctions attracted too few bidders to establish a clearing rate, resulting in the inability of ARS holders to sell their long-term investments which had turned illiquid. In effect, a market for auction-rate securities has ceased to exist.

After the collapse of the ARS market, the Financial Industry Regulatory Authority (FINRA), the Securities and Exchange Commission (SEC), and state attorneys general stepped in to negotiate settlements with major broker-dealers on behalf of investors. Large financial institutions—including Bank of America and Citigroup—were ordered to pay back more than $40 billion to investors who said the firms had not fully disclosed to them the risks of ARS investments.