Auction Rate Security

Auction rate securities definition

Auction rate securities are long-term fixed-income investments with terms of twenty to thirty years or more that incorporate periodic adjustments to the interest rate, causing them to behave more like short-term investments since each interest rate adjustment changes the projected return on the investment. As a result, auction rate security investments tend to have a high turnover rate and are often bought and sold during the scheduled Dutch auctions. The underlying assets for auction rate securities are almost always either bonds or preferred stock holdings.

Interest rates for auction rate securities

The interest rates for auction rate securities are determined by Dutch auctions conducted at preset intervals, typically every seven to thirty-five days. Some securities may be reevaluated daily, however. On the day of the Dutch auction, brokers submit their bids to adjust the interest rate, and an auction agent evaluates the various bids and chooses the lowest bid in order to determine the new interest rate for the securities. The revised interest rate will remain in effect until the next auction date, at which time the process will be repeated until the security reaches full maturity. Auction rate securities may be sold at any time, but are most commonly exchanged during the periodic auctions.

Market implications

Typically, an auction rate security is not held to full maturity due to the volatility of its interest rate; instead, it is typically held for a short time and then resold when market conditions make it possible to derive a profit from that sale. Thus, auction rate securities typically are far more liquid than comparable fixed-interest fixed-income investments and combine short-term profitability with long-term interest rate potential. Auction rate securities are typically sold in large blocks, making them a desirable investment for large-scale firms and wealthy individuals; however, they may be priced out of the market for many smaller investors.

Risks of auction rate security investment

While auction rate securities typically offer many of the advantages of short-term investments, they are still long-term securities and, as such, may tie up a significant amount of capital over a long period of time if no buyers can be found for them. This risk was illustrated by the global credit difficulties that emerged in 2008, when the market for auction rate securities dwindled and companies were forced to retain them, contributing to the overall shortage of cash on the market and worsening the situation considerably.
Tim Ord
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