An auction-rate bond has a term of 20 or 30 years but pays interest at an adjustable rate. The rate is reset on a fixed schedule every 7, 14, 28, or 35 days in a modified Dutch auction. The process is similar to the way rates are set when new US Treasury bills are auctioned.
Municipalities and not-for-profit institutions have used these securities successfully to reduce the cost of borrowing for long-term financing.
However, because auction-rate bonds are vulnerable to lowered credit ratings, rising interest rates, and lack of liquidity, auctions for these bonds can fail in situations such as a subprime mortgage crisis.
Failed auctions, in which there are too few buyers, affect both owners and issuers. Bondholders who wish to sell what they assume to be liquid investments cannot do so. At the same time, issuers are forced to pay substantially higher default rates, which are set when the bond is initially sold. This added cost can increase local tax rates.
Some issuers may refinance to conventional long-term bonds when credit tightens. In addition, in 2008, the Securities and Exchange Commission (SEC) ruled that municipal bond issuers can legally bid on their own issues to prevent an auction from failing, provided they disclose their participation.