Auction Rate Security (ARS)
Contents
Demystifying Auction Rate Securities (ARS): A Comprehensive Guide
Understanding Auction Rate Securities (ARS)
Auction Rate Securities (ARS) represent a unique breed of variable-rate debt instruments, offering both flexibility and complexity to investors. Typically structured as long-term bonds or preferred shares, ARS are sold through Dutch auctions, where the interest rate is reset periodically to clear the market at the lowest possible yield.
Navigating ARS Auctions
Before each auction, investors engage in "price talk" with brokers to gauge probable rates, although bids can be submitted outside this range. During the auction, investors bid for shares at specified interest rates, with the clearing rate—the rate paid until the next auction—determined by the auction agent based on submitted bids.
Post-Auction Dynamics
Following the auction, investors whose bid rates are below the clearing rate receive all or part of their desired bid, while bids above the clearing rate remain unfilled. Coupons are paid shortly after each auction, and yields are settled quarterly, attracting investors with their tax-exempt status and slightly higher after-tax yields compared to money market instruments.
The ARS Market Collapse
The ARS market met its demise during the 2008 global financial crisis when major investment banks refrained from acting as bidders of last resort, causing liquidity concerns. This led to failed auctions and rendered ARS illiquid, leaving investors unable to sell their long-term investments. Regulatory bodies intervened, negotiating settlements with broker-dealers to compensate investors for the lack of disclosure regarding ARS risks.