The issue is important because it reflects on whether auction rate preferred stock is a viable financial innovation that enhances the completeness of the market, or whether it more closely resembles a "speculative balloon" slated for virtual extinction.
The approach here includes an empirical analysis of the redemption decision along with a summary of the results to a mail survey of 51 companies that have called their auction rate preferred stock for redemption.
The decision to issue auction rate preferred stock or to redeem an outstanding issue depends partially upon whether the security is the lowest cost source of capital on a risk-adjusted basis.
A well-known risk associated with auction rate preferred stock is the "failure" of an auction.
By design, the principal clientele within the market for auction rate preferred stock is comprised of corporate cash managers attempting to maximize the after-tax yield on liquid reserves.
We hypothesize that the contraction of the market for auction rate preferred stock, in part, reflects the outcome of a natural selection process by which risk-averse corporate cash managers, virtually the only participants on the demand side of this segmented market, flee the high-risk sector.
Because these limitations apply to auction rate preferred stock issued after November 17, 1989, they serve to limit the tax arbitrage opportunities available from selling new bankruptcy-remote issues.