Auction Rate Bonds (ARB): Definition, How They Work, and Pros & Cons
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Summary:
An auction rate bond (ARB), also known as an auction rate security (ARS), is a type of debt security with an adjustable interest rate and fixed maturities ranging from 20 to 30 years. ARBs are utilized by non-profit institutions and municipalities to reduce borrowing costs for long-term financing. However, since 2008, the demand for ARBs has significantly declined, leading to illiquidity in the market.
What is an auction rate bond (ARB)?
An auction rate bond (ARB), also referred to as an auction rate security (ARS), is a type of debt security characterized by an adjustable interest rate and fixed maturities spanning from 20 to 30 years. These bonds are commonly utilized by non-profit institutions and municipalities as a means to mitigate borrowing costs for long-term financing.
The basics of an auction rate bond
Many investors were attracted to auction rate bonds due to their high investment grade rating, tax-exempt status, and cash-equivalent nature. Despite these advantages, ARBs are no longer actively traded in the market. They generally offer a slightly higher after-tax yield compared to money market funds and certificates of deposit (CDs) due to their increased risk and complexity. However, auction rate bonds lack the liquidity of money market funds and CDs, which may hinder their tradability.
An auction rate bond’s interest rate is determined through a modified Dutch auction. In this auction structure, investors place bids for the amount they are willing to buy and the yield they expect to receive. The interest rates on auction rate bonds are periodically reset every 7, 14, 28, or 35 days, as dictated by the terms of the bond agreement.
Example of Dutch auctions and ARBs
For instance, if an investor is interested in investing in a company that is conducting an initial public offering (IPO) using a Dutch auction model, they would submit a bid along with other interested investors. The bid specifies the number of shares and the price the investor is willing to pay. Once all bids are collected, the company sets the price for all shares at the cost of the lowest accepted bid. Similarly, the U.S. Treasury employs a Dutch auction structure to sell its securities.
Frequently asked questions
What are the benefits of investing in auction rate bonds?
Auction rate bonds may offer a higher after-tax yield compared to money market funds and CDs. They often come with high investment grade ratings and can be utilized by non-profit institutions and municipalities to reduce borrowing costs.
Are auction rate bonds considered liquid investments?
No, auction rate bonds lack liquidity compared to money market funds and certificates of deposit (CDs), making them less tradable in the market.
How are interest rates determined for auction rate bonds?
Interest rates for auction rate bonds are determined through a modified Dutch auction process, where investors bid on the amount they are willing to buy and the yield they expect to receive.
What is the duration of an auction rate bond?
An auction rate bond typically has a fixed maturity period ranging from 20 to 30 years.
Key takeaways
- ARBs are commonly used by non-profit institutions and municipalities to reduce borrowing costs for long-term financing.
- Interest rates for ARBs are determined through a modified Dutch auction process, with rates periodically reset every 7, 14, 28, or 35 days.
- Pros of ARBs include potentially higher after-tax yields compared to money market funds and CDs, along with high investment grade ratings.
- Cons of ARBs include lack of liquidity, complexity, and the decline in demand since 2008.
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