What is an Auction Rate Guarantee (ARS)?
An auction rate security (ARS) is a floating rate type of debt security that is sold through a Dutch auction. An ARS is generally a bond with a long-term maturity of 20 to 30 years or preferred shares issued by a closed fund. ARS is sold at an interest rate that will settle the market with the lowest possible yield. This ensures that all bidders for an ARS receive the same return on issuing debt. The interest rate of an ARS is readjusted periodically through additional auctions, generally every seven, 14, 28 or 35 days.
During the 2008 global financial crisis, the ARS market flopped when auctions failed to attract enough bidders to set an offset rate. This meant that many investors were left with investments with long maturities that they could not sell.
$ 330 billion
The estimated amount of money invested in auction-rate securities before the market crashed in 2008.
- An auction rate security (ARS) is a type of variable rate investment that is generally a long-maturing bond or preferred stock.
- The interest rate on an ARS is generally reset every seven, 14, 28, or 35 days via a Dutch auction.
- A Dutch auction is a public auction in which investors bid on the amount of the offer they are willing to buy and the price they are willing to pay.
- The ARS market collapsed during the 2008 global financial crisis, leaving tens of thousands of investors with long-term investments that they could not sell.
Understanding Auction Fee Securities (ARS)
Municipal and corporate issuers seeking low-cost debt and seeking the flexibility of variable rates can opt for the auction rate securities (ARS) route. Auction rate securities are medium and long-term debt issues whose interest rates are determined through a Dutch auction process. In a way, an ARS acts like a shorter-term issue, as interest rates readjust roughly every month. A Dutch auction is a public offering auction structure in which the bid price is set after taking all bids and determining the highest price at which the total bid can be sold.
Before the ARS auction
ARS auctions are held every seven, 14, 28, or 35 days, at which point rates are reset. Before the auction, brokers discuss the range of possible ARS rates with their clients. This discussion, known as “price talk,” provides clients with a basis for likely rates, but investors are free to bid outside of this range.
Investors enter a competitive bidding process by submitting offers that specify the number of shares, in denominations of $ 25,000, that they are willing to buy and the lowest interest rate they would be willing to accept on the bond.
Bids are accepted until the deadline after which the auction agent calculates the compensation rate based on the bids submitted. The offset rate is the interest rate that will be paid on the securities until the next auction.
After the ARS auction
If the investor’s offer rate is less than the compensation rate, the investor will receive all or part of the desired offer. Offers placed in excess of the compensation rate will not be completed. Coupons are paid out shortly after each auction period ends and the yield is settled each quarter. Investors are attracted to these securities due to the high investment grade ratings, plus the fact that they are exempt from federal, state, and local taxes. ARS also provides a slightly higher after-tax return than money market instruments due to its complexity and increased risk.
The collapse of the ARS market
In February 2008, the ARS market failed when the market’s top four investment banks (Citigroup, UBS AG, Wachovia and Merrill Lynch) refused to act as last resort bidders due to liquidity problems. The brokers who sold these securities on behalf of the issuers led the buyers to believe that they were liquid.
When the ARS downside came to light, the auctions attracted too few bidders to set an offset rate, resulting in the inability of ARS holders to sell their long-term investments that had become illiquid. In effect, an auction-type stock market has ceased to exist.
After the ARS market crash, the Financial Industry Regulatory Authority (FINRA), the Securities and Exchange Commission (SEC), and state attorneys general stepped in to negotiate deals with major stockbrokers on behalf of investors. Large financial institutions, including Bank of America and Citigroup, were ordered to return more than $ 40 billion to investors who said the companies had not fully disclosed the risks of investing in ARS.