CDFA Spotlight: Use Variable Rate Demand Obligation Bond Indexes to Sell IDB Rate Savings By Stan Provus

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A large number of Industrial Development Bonds for manufacturers (qualified small issues) are structured as Variable Rate Demand Obligation (VRDO) bonds secured by direct pay letters of credit (LOC) provided by rated commercial banks. Although the interest rate on VRDO bonds can be reset (“remarketed”) for periods ranging from 1 day to 270 days, the majority are remarketed on a weekly basis, so called “low floaters.” VRDO bonds provide long-term financing at short-term interest rates. In other words, the interest rate changes weekly, and the borrower pays the average of the weekly rates to the bond trustee, once a month, in a structure that provides for monthly interest payments. Principal is often paid semi-annually.

Many prospective manufacturing IDB customers are smaller, closely held businesses that are accustomed to prime based loans to finance their expansion projects (land, buildings, equipment). They are not familiar with VRDO bonds and their historical interest rate levels. In marketing the VRDO, LOC-secured structure as one alternative for accessing the capital markets (others such as direct purchase will be the subject of a future article) it is important to explain the mechanics of VRDO bonds and historical interest rate levels relative to prime.

Beyond the weekly reset of interest rates by the remarketing agent, low-floater bonds are also characterized by a “put” or demand feature. These bonds are issued at par and give the bondholder the option to “put” their bonds back to the remarketing agent, at par, with sufficient notice, meaning they have the right to sell their bonds back at par. Since the interest rate paid on low floaters is reset weekly to provide the required market yield at par value, thereby keeping the rate current to market conditions, there is reduced risk that bondholders will actually exercise the demand feature. Should the bondholder exercise the put feature, the weekly resetting of the interest rate to current market rates should allow an issuer’s remarketing agent to simultaneously resell the bonds at par to another investor, providing funds to honor the put. To provide liquidity, cash needed to honor a put, in the unlikely event the put bonds cannot be remarketed to another bond investor, the letter of credit securing the bonds can be drawn upon to purchase put bonds. Letters of credit securing VRDO bonds, therefore, assume both credit risk, the risk the borrower will not make timely interest and principal payments in which case the LOC bank makes the payments and secondly, provide for liquidity in the event put bonds can not be remarketed to other bond investors.

VRDO bonds secured by LOCs also give borrowers flexibility. Typically, a manufacturing borrower can prepay VRDO bonds in whole or part without prepayment penalties with sufficient notice to the trustee (usually 30-45 days notice). Principal amortization terms and amounts are negotiated with the LOC bank provider and specified in the “ reimbursement agreement” between the LOC provider and borrower.

Although VRDO bonds provide long term financing at short term interest rates, borrowers should also understand that the initial term of many LOCs is only 3-5 years, and the LOC must be renewed at each expiration date until bonds are paid in full.

VRDO Bond Indexes

One of the best VRDO bond indexes that can be readily accessed at the Bond Market Association (BMA) web site (WWW.Bondmarkets.com) is the BMA Swap Index. The BMA Swap Index, produced by Municipal Market Data, is a high-grade market index comprised of tax-exempt VRDO bonds (low floaters). The index shows benchmark VRDO rates. Issuers can access weekly VRDO historical rates over the past ten years from the BMA web site. The index basically reflects average weekly low-floater rates of some 250 outstanding VRDO issues in the market.

From 1990-2000, the weekly BMA Index rate averaged 3.64%. During this same time period, Prime averaged 8.09%, meaning low-floater rates averaged 45% of prime. However, since the BMA Index is comprised of non-AMT issues of $10 million or more, the historical BMA average should be adjusted upward about 10-20 basis points if it is used for benchmark IDB rates. This is because qualified small issues for manufacturers (IDBs) are subject to AMT and the typical issue size is in the $2.5-$8 million range. These factors command somewhat higher interest rates.

Depending on the nature of an issuer’s IDB program and how aggressively up-front and annual fees are negotiated with industry professionals ( bond counsel, placement agent, remarketing agent, trustee), and annual LOC fees, it is not uncommon for the “all-in” VRDO bond rate to average 30% below the prime lending rate.

This article is intended to provide accurate and authoritative information in regard to the subject matter covered. The author and CDFA are not herein engaged in rendering legal, accounting or other professional services, nor does it intend that the material included herein be relied upon to the exclusion of outside counsel. CDFA is not responsible for the accuracy of the information provided in this fact sheet. The information provided has been collected from a variety of sources. Those seeking to conduct complex financial deals using the tools mentioned in this document are encouraged to seek the advice of a skilled legal/consulting professional.