Auction rate securities are long-term debt instruments, such as corporate or municipal bonds, whose interest rates reset through an auction. The auction is carried out by a brokerage dealer and takes place every 7, 28, or 35 days. Auction rate securities are usually sold in multiples of $25,000 and can be tax-exempt or non-tax-exempt.

Bondholders wishing to sell and investors wishing to buy bonds enter into a bidding competition. Buyers state the amount of shares they wish to purchase and the minimum interest rate they are willing to accept.

The interest rate or “clearing rate” for the upcoming period is determined by the number of shares in which the bonds can be sold. Only buyers whose interest rate bids are equal to or lower than the clearing rate can receive bonds. Buyers are paid interest at the end of the auction period. 

Investors whose minimum bid is above the clearing rate do not receive bonds. A failed auction occurs when there are not enough buyers willing to purchase the shares offered. 

These instruments were introduced to the market in 1988. They appealed to both issuers and investors. Issuers liked the advantages of a variable rate debt as well as the low financing cost. Buyers were attracted to higher rates and higher after-tax yields.

The auction rate securities market collapsed in 2008 when the subprime mortgage crisis hit Wall Street. Investors and dealers could no longer support the market, causing many auctions to fail. Bondholders could not sell their bonds and issuers were forced to pay higher interest rates.

While some issuers have restructured these instruments with fixed rates, the auction rate securities market was, for the most part, frozen after the 2008 collapse.