Auction rate securities are long term investments that pay short-term interest rates to investors. They are fixed income securities that provide a steady stream of revenue to investors at a variable interest rate that changes over the term of the agreement. These financial instruments are issued into the market or sold by corporations and municipal governments as a means to generate capital. There are different types of auction rate securities, and the underlying investment can be either bonds, which are debt instruments, or preferred stocks, which are equity investments. In either case, the common feature is a variable interest rate.
Under the terms of a traditional fixed income investment, the issuer pays investors ongoing interest payments at a set percentage over the term of the loan, followed by a payment for the face value of the contract once the agreement matures or expires. The key difference in an auction rate security is the changing interest rate at which payments are made. These rates are subject to change at every predetermined auction, which typically occurs every seven to 35 days. Investors are free to sell their auction rate securities at these auctions.
Traditionally, auction rate securities become short-term investment vehicles, because auctions are held so frequently. The benefit for investors has always been that they are holding a relatively liquid security that can be bought and sold rather seamlessly. In a liquid investment, buyers and sellers of a security are not hard to find.
Another benefit to investors is that they essentially are investing in a short-term security, because they have the option to sell so frequently, but they typically earn interest rates that exceed other short-term investments. This is because, although auction rate securities are technically issued as long-term contracts of anywhere from 20 to 30 years, they are liquid investments that can change hands at auctions before the contract expires. Investors in auction rate securities are mainly corporations and wealthy individuals.
In the global credit crisis that unfolded in the financial markets in 2008, the nature of auction rate securities changed. Institutional sellers of these financial instruments were suddenly unable to find buyers at regularly scheduled auctions. Subsequently, holders were forced to hold onto these securities for long periods of time even after some of the issuers defaulted on the agreement. Because some companies rely on auction rate securities as a means to generate short-term cash, the fact that this market suddenly became illiquid played a significant role in the economic upheaval that would ensue.