Mechanics of Auction Rate Securities

The New York Times credited Ronald Gallatin, Lehman Brothers, with inventing auction rate securities (ARS) in 1984. These are long-term debt or preferred stock whose interest is reset in intervals of 7, 28 or 35 days. ARS are issued in the municipal (taxable and non-taxable) and corporate markets, and for closed-end mutual funds. Floyd Norris (NYT) gives an excellent review of the current state of the market in “Auction Yield Chaos for Bonds”.

I will be focusing on the mechanics of the market. The Issue Brief “Auction Rate Securities” from the California Debt and Investment Advisory Commission (on the California State Treasurer’s website) explains municipal ARS. The remainder of this article is based on California.

The ARS are callable at par by the issuer on any interest payment date, but do not contain a put option for investors to force the issuer to buy back the security. ARS do not have a liquidity facility, so a triple-A insurance wrap is required for regular successful auctions. The minimum issue size is $25M in $25K denominations. The investor must hold the ARS until it is sold at a unified auction, is called, or matures. ARS typically contain conversion features to fixed or variable rates. The issue and auction fees are detailed in the document.

Auction actions from the Issue Brief:

“Holders of existing ARS have the option to:

• Hold at Market: hold an existing position regardless of the new interest rate (these shares are not included in auction).
• Hold at Rate: bid to hold an existing position at a specified minimum rate.
• Sell: request to sell an existing position regardless of the interest rate set at the auction.

Potential buyers have the option to:

• Buy: submit a bid to buy a new position at a specified minimum interest rate (new buyers or existing holders adding to their position at a specified interest rate).”

All Buys and Sells are transacted at par. The Dutch auction sets the clearing rate as the minimum bid to fill the Sell and Hold at Rate orders. All investors in the issue would then get the clearing rate for the next action period. The current rate always runs one auction behind. Interest is paid one business day after the auction.

When no clearing bid can be established, the maximum rate in the official statement is set until the next auction. An auction is considered “failed” when there are not enough bids to cover Sell and Hold at Rate offers. When no investors offer supply (Sell or Hold at Rate), the “all hold” rate in the official statement is paid in the next period.

The financial media speaks of alarming municipal “failed auction” rates of up to 20%. But, high rate bidders beware - the high rate may only last one auction period.

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