C ALIFORNIA DEBT AND ISSUE BRIEF INVESTMENT ADVISORY California Debt and Investment Advisory Commission August 2004 C OMMISSION

AUCTION RATE SECURITIES

Douglas Skarr CDIAC Policy Research Unit

The Auction Rate Securities has Securities must carefully evaluate the current expanded significantly in the public environment, their objectives, and consider how sector since 2001. Nationwide, issuance of this debt will be managed over the long term. auction rate securities, including the public finance area, grew from $100 billion in the This Issue Brief provides an overview of the first quarter of 2002 to $200 billion by the end market, mechanics, costs, benefits and risks of the fourth quarter of 2003. Public finance associated with Auction Rate Securities. has become the fastest-growing sector to use auction rate securities, with total issuance I. DEFINITION AND PURPOSE projected to grow at double-digit rates in the Auction Rate Securities (ARS) are long term, future (see Figure 1). variable rate bonds tied to term interest

rates. ARS have a long term nominal Figure 1 – ARS Issues Outstanding with interest rates reset through a modified ARS Outstanding 2002-2003 Dutch auction, at predetermined short term 250 intervals, usually 7, 28, or 35 days. They trade 200 at par and are callable at par on any interest payment date at the of the issuer. 150 Interest is paid at the current period based on 100 the determined in the prior auction

($)In Billions period. 50

0 Although ARS are issued and rated as long term Q1- Q2- Q3- Q4- Q1- Q2- Q3- Q4- 2002 2002 2002 2002 2003 2003 2003 2003 bonds (20 to 30 years), they are priced and Total Municipal traded as short term instruments because of the liquidity provided through the interest rate reset The use of auction rate financing is becoming mechanism. Frequent issuers of municipal more attractive for many reasons, especially ARS include traditional issuers of tax-exempt in comparison to variable rate demand debt such as municipalities, non-profit obligations (VRDO). Auction Rate Securities hospitals, utilities, housing finance agencies, have no “put” or tender feature, no letter-of- student loan finance authorities and universities. credit requirement, and no need for an annual Municipal ARS issues are typically of high short term rating, all of which increase credit quality. Historically, over 75 percent of the cost of issuance and maintenance of the issues sold have received the highest credit VRDO. However, these securities may not be rating available from the major credit agencies, appropriate for all municipal issuers. generally because of bond insurance. Municipalities planning to issue Auction Rate

CDIAC 04-08 1 California Debt and Investment Advisory Commission ARS investors are typically high net worth (e.g. AAA/Aaa) to make them marketable. This individuals (for tax-exempt issues) or is usually achieved with bond insurance. (for taxable issues). market funds are ineligible to hold ARS due II. DUTCH AUCTION MECHANICS to Securities and Exchange Commission Rule 2a-7, restricting them to securities with a final The interest rate on ARS is determined through maturity of 397 days or less. a Dutch auction process. The total number of shares available to auction at any given period

ARS trade at and typically include a is determined by the number of existing bond “multi-modal” conversion feature that allows holders who wish to sell or hold bonds only at a for conversion to long term fixed or variable minimum yield. rate bonds. The usual minimum issue size is $25 million, in denominations of $25,000. Existing holders and potential investors enter a competitive bidding process through In addition to the typical bond issue broker/dealer(s). Buyers specify the number of participants, ARS require a broker/dealer shares, in denominations of $25,000, they wish (either a single underwriter or syndicate of to purchase with the lowest interest rate they are multiple broker/dealers) to structure the issue, willing to accept. underwrite, distribute, and provide and increase liquidity to ARS investors. ARS also Each bid and order size is ranked from lowest require an “auction agent” to receive bids to highest minimum bid rate. The lowest bid from the broker/dealers, determine the rate at which all the shares can be sold at par winning bid and reset rate, and act as liaison establishes the interest rate, otherwise known as between the issuer, brokers, trustees, and the “clearing rate”. This rate is paid on the depositors. entire issue for the upcoming period. Investors who bid a minimum rate above the clearing rate ARS carry the typical up front fees associated receive no bonds, while those whose minimum with a traditional issuance bid rates were at or below the clearing rate along with ongoing annual fees; industry receive the clearing rate for the next period. standard is $5/bond for initial placement fee plus annual fees of 25 basis points for Holders of existing ARS have the option to: broker/dealer fees and 1-2 basis point(s) for auction agent fees. Because ARS have no • Hold at Market: hold an existing position letter of credit requirement, letter of credit regardless of the new interest rate (these fees are eliminated, but additional costs of shares are not included in auction). bond insurance may be necessary. • Hold at Rate: bid to hold an existing position at a specified minimum rate. Credit risk associated with ARS mirror those of other municipal and corporate issues in • Sell: request to sell an existing position terms of default risk associated with the regardless of the interest rate set at the issuer. Because ARS do not carry a “put” auction. feature (which allows the bondholder to require the purchase of the bonds by the Potential buyers have the option to: issuer or by a specified third party), they are • Buy: submit a bid to buy a new position at very sensitive to changes in credit ratings and a specified minimum interest rate (new normally require the highest ratings buyers or existing holders adding to their position at a specified interest rate).

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Figure 2 - Example of Sales Process Figure 3 – Diagram of Auction Process $25,000,000 ARS Issue OUTSTANDING 1,000 SHARES @ $25,000 EACH Current Holders New Bidders AVAILABLE 500 SHARES (INCLUDES ALL SELL AND HOLD AT Hold at Market Buy RATE ORDERS) Hold at Rate Orders Sell Order Filled Placed Bid Bid @ 1.00% Bidder Shares Type Minimum (clearing Solicit Orders Receive Orders Rate rate) 1 100 Buy Any 100 Broker/Dealer 2 200 Hold .90% 200 Clearing Allocation Order Information at Rate Rate 3 100 Hold .95% 100 Auction Agent at Rate 4 200 Buy 1.00% 100 (Partial) 5 100 Sell Any Shares • Investors specify the par amount of are Sold securities they want and what they are 6 100 Hold 1.03% Shares willing to pay. at are Sold Rate • The broker/dealer(s) conveys the bids to the 7 300 Buy 1.03% Not auction agent. Filled • The auction agent, who is a third-party bank 8 200 Buy 1.10% Not Filled selected by the issuer, collects all the bids from all participating broker/dealer(s) on behalf of the investors. Figure 2 illustrates how the “clearing rate” is • The auction agent assembles all the bids in determined for an ARS offering of 500 ascending rate order and determines the shares, made up of (1) orders to sell and (2) clearing rate. orders to hold at rate. In this example, orders • The bids at or lower than the clearing rate for 1,300 shares of different bid types were will receive the bonds. In the event of placed. The clearing bid is 1.00 percent multiple bids at the clearing rate, the auction because it provided the last purchase to agent will allocate securities on a pro-rata clear the auction total of 500 shares. basis. Existing holders receive preference over new bidders at the same rate. The entire orders for bidders 1, 2, and 3, • After selection, the auction agent notifies totaling 400 shares, were filled at the clearing the broker/dealer(s) of the auction results. rate of 1.00 percent. Bidder 4’s 200-share • The broker/dealer(s) record and settle the order was partially filled for 100 shares trades for next day . because a maximum of 500 shares available at this auction was reached. The orders for A “failed auction” can occur due to a lack of Bidders 5 and 6 were sold. Bidders 7 and 8 demand and no clearing bid received. In the had buy orders that were not filled. event of a failed auction, existing holders will hold their positions at the maximum rate set in III. ARS AUCTION PROCESS the official statement until sufficient bids are entered to set a clearing bid at the next auction. Figure 3 provides a diagram of the auction Although the underwriting broker/dealers are process. not required to do so, they can provide a

CDIAC 04-08 3 California Debt and Investment Advisory Commission “clearing bid” to ensure the success of each rather relies on the liquidity generated by the auction and provide liquidity to investors who Dutch auction process and the credit-worthiness wish to sell. Failed auctions are associated of the issuer or insurer. Although no letter of with downgrades in credit quality of either the credit is required, most issues carry bond issuer or insurer of the issue. insurance to elevate them to the highest credit rating. The following table describes typical For auction periods with a lack of supply, differences in features between ARS and where all existing holders wish to continue to VRDO bonds. hold, an “all hold” rate is paid for the next period. This rate is established in the official Figure 4 – Feature Comparison: ARS versus statement and is generally tied to the Bond VRDO Market Association Index (BMA) rates or rates. VRDO ARS

Denominations $100,000 $25,000 (Tax- Interest is paid by a trustee or paying agent. Exempt) Figure 4 – Comparison of ARS and VRDO- Interest payments to holders in the current $50,000 Features month will be based on the interest rate (Taxable) determined in the prior month’s auction Interest Rate Daily, weekly, 7 day (Non- period. This lag time is necessary to provide Period monthly, etc. AMT), 28 day time for clearing and administration of the (Taxable), 35 day (AMT) payments. Interest Monthly or Business day

Payment Rate Semi-Annually following the IV. ARS COMPARED TO VARIABLE auction RATE DEMAND OBLIGATIONS Change of Yes Yes Interest Rate

ARS are an alternative to variable rate Period demand obligation (VRDO) bonds. A VRDO Insurance Must at least Typically is a security for which the interest rate is reset have a liquidity Insured facility periodically, typically through a remarketing Credit AA/Aa or better AAA/Aaa process, or according to a specified index. Enhancement plus liquidity The bond’s demand feature permits the Remarketing Yes Broker/dealer bondholder to require the purchase of the bonds by the issuer or by a specified third Tender or “Put” Yes No (subject to party, either periodically, at a certain time mandatory purchase on prior to maturity, or upon the occurrence of specified events or conditions. This process conversion date to another mode) is often referred to as "putting" a bond or Redemption Callable on any Callable on any exercising a "tender option”. Interest rates are Provisions interest payment interest payment generally based on market conditions and the date at par value date at par value length of time until the bondholder can exercise the put option. Because of the put Typical Mainly money Corporate and Investor market funds, high net worth feature, the VRDO normally requires a bank corporate investors, bond letter of credit. investors, high funds, and bank net worth trust departments Whereas a VRDO would generally require a investors to a lesser extent letter of credit, ARS do not because the investor does not possess a put option but

CDIAC 04-08 4 California Debt and Investment Advisory Commission V. CONSIDERATIONS IN ISSUING ARS The interest rate on ARS is usually slightly higher than that of VRDO, which would The following items should be reviewed and generally result in a higher cost of funds for analyzed when considering the issuance of the borrower. In addition, the upfront fee ARS. (e.g. initial placement fee) associated with ARS is generally higher than that of VRDO. ARS have lower interest costs than fixed rate However, the cost of obtaining a letter of debt credit in an issuance of VRDO, along with risks associated with the elimination and/or Over the past 10 years (through 2004) the renewals of the letter of credit, can make the spread between long term (fixed) and short term cost of funds for an issuance of VRDO on par (variable) debt has been significant. Figure 6 or even more expensive than that of an shows the 10-year historic interest rate issuance of ARS. advantage comparing The Bond Buyer 20 Year GO index (fixed rate average) with the Bond All costs associated with the issuance (e.g., Market Association Index (variable rate bond insurance, broker and auction fees) average). For 2004 the spread is about 3.5 should be considered in the decision to issue percent. ARS (see Figure 5). Figure 6 - Historic Trends in Interest Rates Figure 5 - Cost Comparison: ARS versus VRDO

Long Term vs Short Term Rates 1995-2004

ARS VRDO Rate (%) 7 Interest Rate +-BMA Index +-BMA Index 6

Letter of Credit N/A +65 Bp** 5 Bond Insurance +7 Bp N/A 4

3 Cost of Issuance +5 Bp +3 Bp

2 Bond Buyer 20 Year GO Index Remarketing +25 Bp +9 Bp Bond M arket Association Swap Index (BM A) 1 Fee - Auction Agent +1 to +3 Bp N/A 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Fee *Estimated costs are current as of 2004. ** +Bp = additional costs measured in basis points associated with issuance ARS have higher risk than fixed rate debt ARS, as shown in Figure 5, have additional unique and required costs. The nature of the ARS are long term variable rate debt with instrument requires a broker or remarketing interest payments determined on a 7, 28, or 35- agent to solicit investors, an auction agent to day basis. In periods of sustained rising rates, facilitate the periodic auctions, a trustee to interest expense and volatility will rise. Issuers manage payments and in most cases, bond must be aware of the potential impact rapidly insurance to elevate the credit quality of the rising rates will have on forecasted debt service issue to an AA or AAA rating. and cash needs.

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Depending on the issuer’s tolerance for risk, it Government Finance Officer’s Association may require supplemental hedging strategies (GFOA) offers guidelines for issuing variable to mitigate the variability of interest rates. rate debt Issuers employ a variety of mechanisms to lower or eliminate interest rate risk and The Government Finance Officer’s Association volatility. The most common are interest rate (GFOA) has issued recommendations and caps and interest rate swaps. guidelines for the issuance of variable rate debt. These recommendations apply to ARS as well • Interest Rate Cap as VRDO bonds or any other variable rate debt An interest rate cap is used when a instrument. variable rate bond issuer enters into a contract with a counterparty (typically a They include the following: financial institution) to maintain interest rate payments within pre-established • Review statutes or ordinances governing the limits. In effect, the bond issuer is buying issuance of debt to ensure that issuance of an insurance policy to protect it against ARS is permitted and understood. high interest rate payments on its variable rate bonds. The counterparty takes the • Ensure that the government’s debt policy obligation to pay rates above the cap specifically addresses the use of ARS. level. • Consider the ability of the government to • Interest Rate Swap manage ARS, including staff requirements Many variable rate issuers use interest rate to monitor market conditions; record swaps to hedge their interest rate risk. interest rate changes; make adjustments to Interest rate swaps permit borrowers to budgets and financial plans as needed; and convert variable rate cash flows into fixed manage relationships with investors, rate cash flows without changing the liquidity providers, and remarketing agents. structure of the underlying bond issue. Variable rate borrowers who want to fix • Evaluate the impact on debt service borrowing costs pay a fixed amount to the requirements assuming different interest financial institution, which in turn pays a rate scenarios and develop appropriate floating amount to the borrower to settle contingency plans for rising interest rates. the underlying variable rate loan obligations. • Consider the impact of changing interest rates on rate covenants and an issuer’s Increases in an issuer’s variable rate debt financial position. ratio may negatively impact its credit rating • Evaluate the total cost of issuing ARS debt, including fees to brokers, auction agents As a general rule, some rating agencies and trustees, bond insurance costs, recommend that variable rate debt not exceed additional internal resource needs, and 20 percent of total debt outstanding, although possible use of instruments such many factors may affect the evaluation of the as interest rate caps and swaps. appropriate level.

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VI. CONCLUSION

ARS can be a valuable alternative and complement to fixed rate debt in a government borrowing program.

Governmental issuers considering issuing

ARS must carefully evaluate their objectives and how this debt will be managed over the long term. Issuance of ARS or any variable rate debt should be guided by the government’s overall financial and debt management objectives and its financial condition.

The use of ARS can provide significant benefits including: (1) reducing total interest costs, (2) diversifying the debt portfolio, (3) allowing the opportunity to take advantage of current short term variable interest rate trends, and (4) matching the structure of assets to liabilities.

ARS, however, carry more risk than fixed rate bonds, but these risks can be offset with the appropriate use of derivative products like interest rate caps and variable to fixed interest rate swaps.

ARS, like other variable rate debt instruments, require a greater commitment of time and expertise by staff managing the program. In addition, specific policies regarding the use of variable rate debt must be conformed to the issuer’s statutes and addressed with credit rating agencies.

*** Thanks and acknowledgement to: Mr. Shafiq Jadavji, Vice President, Deutsche Bank Trust Company Americas for providing his input to this report.

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