AUCTION RATE BOND Meaning and
Definition
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An auction rate bond refers to a type of long-term bond that has a variable interest rate, which is determined through a periodic auction process. These bonds are typically issued by municipalities, student loan agencies, or closed-end mutual funds to raise capital for various projects and financial needs.
During an auction, bondholders, typically institutional investors, submit bids stating the lowest interest rate they are willing to accept to hold the bond until the next auction. The interest rate is then set based on the lowest bids that meet the issuer's requirements. This process is usually conducted at predetermined intervals, such as every seven, twenty-eight, or thirty-five days.
Investors who hold these auction rate bonds can usually sell them before the next auction in a highly liquid secondary market. However, there are instances where the auctions fail due to insufficient demand, leading to illiquidity and the inability to sell these bonds. This illiquidity can result in investors being stuck with the bonds until a successful auction takes place, or seeking alternative means to exit their investment, potentially at a loss.
These bonds often offer relatively higher interest rates compared to traditional fixed-rate bonds, which can attract investors seeking potentially higher returns. However, investing in auction rate bonds also entails a higher level of risk and requires careful consideration of an investor's liquidity needs and risk tolerance.
