I’m hearing this term with increased frequency as part of the bubble that has burst due to the subprime mortgage mess. I don’t fully understand how ARS’s differ from just buying muni bonds.
An "Auction Rate Security" is a bond where the issuer periodically resets the interest rate by having an auction. During the auction, prospective buyers bid on the number of bonds they want, and the minimum interest rate they are willing to accept. The current owners of the bonds can offer their bonds for sale unconditionally, they can offer them below a particular interest rate, or they can decline to offer them for sale. All of the bids are ranked, from lowest to highest interest rate. The lowest interest rate at which all available bonds will be sold becomes the new interest rate for the next period.
An example may make this clearer: Let’s say that ABC, Inc. has sold 5,000 units of an ARS, and it’s time to hold another auction. Holder 1 owns 2,500 units, and doesn’t want to sell. Holder 2 owns 1,500, and will sell below 3.75%. Holder 3 owns 750, and will sell below 4%. Holder 4 owns the remaining 250, and will sell at any interest rate.
If the bids come in like this:
200 – 3%
300 – 3.5%
500 – 3.8%
750 – 4%
1000 – 4.5%
Then the auction would close at 3.8%, and Holder 3 and Holder 4 would each sell their positions. That’s because at 3.8%, 1000 units would be sold, and there are 1000 units available below 3.8%.
If there aren’t enough bids to cover everyone who is willing to sell, then the auction is said to fail, and the interest rate is set as stipulated in the underlying offering. Incidentally, it’s the recent rash of failed auctions that are putting the spotlight on ARS now; the subprime mess has made investors skittish about debt instruments. This basically means that if you bought some of these bonds, you’ll be stuck with them for a while.