Auction Rate Madness

When most people think of bonds they usually have one of two kinds of bonds in mind; tax free municipal bonds or treasury bonds. When it comes to fixed income securities there are many types to choose from. They range from your basic municipal bond and treasury securities to the more complex asset backed securities, auction rate securities, and bond futures. The more sophisticated the investment the more restrictions they come with.

An example of that is the minimum set on Auction Rate Securities which is $25 thousand dollars. This will usually weed out the smaller newer type of investor that could be more prone to misunderstandings that could result in loss of capital.

Auction rate securities are similar to that of a muni bond or corporate bond, but they come packaged with a twist. They have a coupon rate that changes periodically during the life of the bond. Rates are set each time there is an auction. Auctions are usually held every 7, 28, or 35 days. Some reset every 91 days or semi or even annually.

The interest rate on Auction Rate Securities is determined by what is called a Dutch auction. The number of shares available to auction depends on the number of existing bond holders who wish to sell or hold bonds at a minimum yield. Buyers specify the number of shares they want to purchase and the minimum yield they are willing to accept. Each bid and order size is ranked by yield from the highest to the lowest. The lowest rate at which all shares can be purchased is called the clearing rate and all securities offered that day are offered at the clearing rate. Any investor whose minimum rate was above the clearing rate received no bonds.

In 2008 the Auction Rate Security market was at $200 billion and in February of that same year auctions began to fail as investors declined to bid on the securities. Then the four largest banks who make a market in the securities failed as bidders of last resort. On Feb. 2008 nearly eighty percent of all auctions failed and accounts were frozen.

As you can see here, fixed income investing has a lot more to offer than a plain vanilla municipal bond that is held till maturity. Its market dwarfs the equity market and the range of ways to make money from fixed income is only limited to your imagination. Some investors will stick to the most basic form of bond investing possible, while you have very sophisticated investors who are making money, and losing some, in any number of ways, like CMO’s or Auction Rate Securities.

Good luck and happy bond investing.