An auction rate security (ARS) is a long-term debt instrument whose interest rate is adjusted through a Dutch auction. Municipal and corporate bonds and preferred stock issues can be classified as ARS. The auction rate mechanism was introduced in the late 1980s, and the new interest or dividend rate is typically the lowest rate selected. The reset date is when the interest rate changes. Some investors consider ARS an excellent investment opportunity, while others are not in favor of it due to reduced bank liquidity and a drop in the coupon rate.
An auction rate security, ARS, is a type of debt instrument in which the interest rate is altered after the instrument is issued. Typically, this interest rate change is made using a process known as a Dutch auction. Municipal bonds and corporate bonds are two common examples of an auction rate guarantee, although preferred stock issues can also be classified this way.
Debt instruments that can be classified as auction rate securities share a couple of characteristics. First, the instrument has 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 allow the interest rate to be adjusted through the Dutch auction mechanism. It is important to note that not all types of bonds or preferred stock issues fit into this category.
The concept of adjusting interest rates at auction was first introduced in the late 1980s. During the auction, a broker or dealer submits an offer to adjust the current interest rate on a bond, or the current dividend on a given preferred stock issue. The offer is sent to an auction agent, once it is declared open. When the auction declares the bidding closed, he or she will evaluate the bids and determine the new interest or dividend rate. This is typically the lowest rate that will be selected and assigned to the auction rate security. The date the interest rate changes is typically known as a reset date.
Depending on the market involved, an auction rate guarantee can be auctioned anywhere from every seven days to thirty-five calendar day intervals. There are some classes of values that can appear daily, with reset dates appearing periodically throughout the month, quarter, and year. However, some securities may be resettled the next business day after the close of the auction.
Many investors consider an auction rate guarantee to be an excellent investment opportunity. However, there are those who are not in favor of this type of investment strategy. Commonly cited problems with the concept of auction rate safety is that the process can reduce overall bank liquidity and can also create a drop in the coupon rate.
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