What is an Auction Rate Security?

An auction rate security, ARS, is a type of debt instrument in which the interest rate is altered after the issuance of the instrument. Normally, this change in the interest rate is conducted with the use of a process known as a dutch auction. Municipal bonds and corporate bonds are two common examples of an auction rate security, although preferred stock issues can also be classified in this manner.

Debt instruments that can be categorized as being auction rate securities share a couple of characteristics. First, the instrument carries a nominal maturity that is considered long term rather than short term. Second, the terms and conditions related to the issuance of the debt instrument allows for the interest rate to be adjusted through the mechanism of the dutch auction. It is important to note that not all bond types or preferred stock issues fit into this category.

The concept of adjusting interest rates in an auction setting was first introduced in the late 1980s. In the course of the auction, a broker or dealer submits a bid to adjust the current rate of interest on a bond, or the current dividend on a given preferred stock issue. The bid is submitted to an auction agent, once the bidding is declared open. When the auction declares the bidding to be closed, he or she will evaluated the bids and determine the new interest rate or dividend. Usually, it is the lowest rate that will be selected and assigned to the auction rate security. The date that the interest rate is altered is normally known as a reset date.

Depending on the market involved, an auction rate security may come up for auction anywhere from every seven days up to intervals of thirty-five calendar days. There are a few classes of securities that may appear on a daily basis, with reset dates appearing periodically during the month, quarter, and year. However, some securities may resettle on the following business day after the close of the auction.

Many investors find an auction rate security to be an excellent investment opportunity. However, there are those who are not in favor of this type of investing strategy. Commonly cited issues with the concept of the auction rate security is that the process can lower bank liquidity in general and also can create a drop in the coupon rate.