Auction rate securities are long-term investments that pay short-term interest rates to investors. They are fixed income securities that provide a constant stream of income to investors at a variable interest rate that changes over the life of the agreement. These financial instruments are issued on the market or sold by companies and municipalities as a means of generating capital. However, the global credit crisis in 2008 changed the nature of auction rate bonds, making them illiquid and playing a significant role in the economic turmoil that ensued.
Auction rate securities are long-term investments that pay short-term interest rates to investors. They are fixed income securities that provide a constant stream of income to investors at a variable interest rate that changes over the life of the agreement. These financial instruments are issued on the market or sold by companies and municipalities as a means of generating capital. There are different types of auction rate securities, and the underlying investment can be bonds, which are debt instruments, or preferred stock, which are equity investments. In both cases, the common feature is a floating interest rate.
Under the terms of a traditional fixed income investment, the issuer pays investors an outstanding interest payment at a specified percentage over the life of the loan, followed by a payment for the face value of the contract once the contract expires or expires. The key difference in an auction rate bond is the variable interest rate at which payments are made. These rates are subject to change with each predetermined auction, which typically occurs every 35 to 35 days. Investors are free to sell their securities at the auction rate at these auctions.
Traditionally, auction rate securities have become short-term investment vehicles because auctions are held so frequently. The benefit to investors has always been to hold a relatively liquid stock that can be bought and sold fairly seamlessly. In a liquid investment, it’s not hard to find buyers and sellers of a stock.
Another benefit for investors is that they are essentially investing in a short-term stock, because they have the ability to sell so frequently, but typically earn interest rates that outpace other short-term investments. This is because, although auction rate notes are technically issued as long-term contracts for 20 to 30 years, they are liquid investments that can change hands at auctions before the contract expires. Investors in auction rate securities are primarily wealthy individuals and corporations.
In the global credit crisis that erupted in financial markets in 2008, the nature of auction rate bonds changed. Institutional sellers of these financial instruments were suddenly unable to find buyers at regularly scheduled auctions. Subsequently, the holders were forced to hold these securities for long periods of time even after some of the issuers defaulted on the agreement. Since some companies rely on tender rate securities as a means of generating short-term liquidity, the fact that this market suddenly became illiquid played a significant role in the economic turmoil that would ensue.
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