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Home My WebLink AboutCDIAC Brief cu FOxNU ISSUE BRIEF xr nnn Avr ir. August 2004 California Debt and Investment Advisory Commission AUCTION RATE SECURITIES Douglas Skarr CDIAC Policy Research Unit The Auction Rate Securities market has Securities must carefully evaluate the current expanded significantly in the public finance 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 This Issue Brief provides an overview of the finance area, grew from $100 billion in the market, mechanics, costs, benefits and risks first quarter of 2002 to $200 billion by the end associated with Auction Rate Securities. of the fourth quarter of 2003. Public finance has become the fastest-growing sector to use I.DEFINITION AND PURPOSE auction rate securities, with total issuance 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 short term interest rates. ARS have a long term nominal maturity 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 zoo at par and are callable at par on any interest payment date at the option of the issuer. 150 Interest is paid at the current period based on m 100 the interest rate determined in the prior auction s period. 50 o Although ARS are issued and rated as long term D i. °� °' °° bonds (20 to 30 years), they are priced and s zoos zoos zoos icipal traded as short term instruments because of the liquidity provided through the interest rate reset mechanism. Frequent issuers of municipal The use of auction rate financing is becoming ARS include traditional issuers of tax-exempt more attractive for many reasons, especially debt such as municipalities, non-profit in comparison to variable rate demand hospitals, utilities, housing finance agencies, obligations (VRDO). Auction Rate Securities student loan finance authorities and universities. have no "put" or tender feature, no letter-of- Municipal ARS issues are typically of high credit requirement, and no need for an annual short term bond 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 rating available from the major credit agencies, VRDO. However,these securities may not be generally because of bond insurance. appropriate for all municipal issuers. Municipalities planning to issue Auction Rate CDIAC 04-08 1 California Debt and Investment Advisory Commission Figure 2-Example of Sales Process F.. ...3 D-i.a...... f.Auction Process $25,000,000 ARS Issue Current Holders New Bidders OUTSTANDING 1,000 SHARES @$25,000 EACH Hold at Market Buy }. AVAILABLE SOO SHARES(INCLUDES ALL SELL AND HOLD AT Hold at Rate RATE ORDERS} -- ^- —.. Orders-------------------- Sell s Order Filled Placed Bid Bid @ 1.00% Receive Orders Bidder Shares Type Solicit Orders Minimum (clearing Rate rate) ;. 1 100 £ Buy Any 1 100 ( Broker/Dealer 2 Y 200 Hold .90% 200 Clearing Allocation � � Order Information at Rate Rate 3 100 Hold Auction Agent at ................................................................................. Rate .................._................ 4 200 Buy 1.00% 100 -. (P '�� . Investors specify the par amount of Shar - 5 100 Sell Any es are Sold securities they want and what they are , i 100 -Hatold 1.03% Shares are Sold willing to pay. � . The broker/dealer(s) conveys the bids to the Rate 7........ 300 Buy �- 1.03% Not auction agent. Filled . The auction agent,who is a third-party bank 8 1 200 1 uy 1.10% Not l selected by the issuer, collects all the bids Filled � 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 share 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 business day settlement. 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 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 Swap 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 Tenn vs Short Term Municipal Bond Rates 1995 2004 Rate(%) +-BMA Index +-BMA Index 6 N/A +65 Bp** 5 - r N/A 4 +3 B g 2 ( _�BondBuyer20Year G0 Ind ex +9 Bp Ind (BMA) iy +1 to+3 Bp N/A 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 e� *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. CDIAC 04-08 5 California Debt and Investment Advisory Commission VI. CONCLUSION ARS can be a valuable alternative and complement to fined 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. CDIAC 04-08 7 Califomia Debt and Investment Advisory Commission