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CDFA Spotlight:
Auction Rate Securities

By Stan Provus

Preface

This article discusses auction rate securities (ARS). There are two primary variable interest rate products in the municipal marketplace. These are ARS and variable rate demand obligation bonds (VRDO). Between 2000-2005, municipal issuers issued about $164 billion of ARS and $283 billion of short-term, variable rate demand obligation bonds. In 2005, ARS accounted for 8.1% of municipal issuances, while short-term variable rate bonds accounted for 15.3% of total volume. The ARNS market has grown steadily since the mid-1990’s when ARS accounted for only 1% of volume. According to the five major auction agents, at year-end 2005 there were $263 billion of auction rate securities outstanding, of which 46% was municipal debt.

Issuers need to understand how ARS work and their advantages and disadvantages relative to variable rate demand obligation bonds (VRDO). Although it is beyond the scope of this article, issuers should understand that the increase in the use of ARS and VRDO’s is, in part, driven by growth in the muni interest rate swap market - particularly, issuing variable rate debt and swapping for fixed.

Auction Rate Securities (ARS)

Similar to daily and weekly floaters (variable are demand obligation bonds (VRDO)), auction rate securities (ARS) trade at par. ARS are sold through a Dutch Auction, which is a competitive bidding process used to determine rates on each auction date. Bids are submitted to the auction agent. The winning bid rate is the rate at which the auction "clears", meaning the lowest possible interest rate that equals the cumulative total of securities demanded (buyers) to the amount auctioned (sellers).

Auction rate securities are long term, variable rate bonds tied to short-term interest rates. ARS have a long term nominal maturity with interest rates reset through a modified Dutch Auction, at predetermined short term intervals, usually 7, 28, or 35 days. They trade at par and are callable at par on any interest payment date at the option of the issuer. Interest is paid at the current period based on the interest rate determined in the prior auction period.

Dutch Auction Mechanics

In a Dutch Auction potential or existing ARS bondholders may submit orders to hold, sell or bid for bonds to the auction agent at each interest reset date. Buyers specify the number of shares, in denominations of $25,000. The auction agent receives bids from broker/dealers, determines the winning bid and resets the rate and acts as liaison between the issuer, brokers, trustees, and security depositors. The winning bid rate is the rate that, in combination with all lower bid rates, clears the market of the entire principal amount of ARSs available for sale and becomes the interest rate on all bonds until the next auction.

Hold Orders at Market are orders from existing ARS holders who wish to hold the amount of securities specified regardless of the winning rate—these bondholders get the new interest rate once it is set. These shares are not included in the auction. Sell Orders are orders from existing holders who wish to sell all or part of their holdings, regardless of the interest rate set at the auction. Hold at rate are orders from existing holders who wish to hold the amount of securities specified only if the winning rate equals or exceeds a specified rate (if the clearing rate is lower than the specified rate, they are obligated to sell the securities they hold), or (b) orders from existing or potential holders who wish to buy a specified amount of securities at a specified rate. Potential buyers may submit a bid to buy a new position at a specified minimum interest rate, including new buyers or existing holders adding to their position at a specified interest rate.

The Auction Agent, who receives all bids, ranks the orders by rate. Hold orders are allocated first and if there are any sell orders, the Auction Agent then accepts bids with the lowest rate and then successively higher rates, until all sell orders are filled. The lowest bid rate at which all potential sellers can sell their positions, and at which holders that are holding securities at rate can hold their positions, becomes the interest rate that is used for all securities until the next auction date. If an auction fails because sell orders exceed buy orders, or if it fails for any other reason, existing holders must hold their positions until the next auction date. The investors will receive the maximum interest rate specified in the issuer’s official statement.

The following figure illustrates how the “clearing rate” is determined for an ARS offering. The figure assumes a $30 million ARS offering, with 1200 shares outstanding at $25,000 each, and 600 available shares, consisting of orders to sell and hold at rate.

Example of Sales Process
Bidder
Order placed Shares
Bid type
Bid Minimum Rate (minimum acceptable bid)
Orders filled

At the clearing rate

1
100
Buy
Any Rate
100
2
250
Hold at Rate
3%
250
3
150
Hold at Rate
3.25%
150
4
200
Buy
3.30%
100

(Partial)

3.30% is the clearing rate

5
100
Sell
Any Rate
Shares are sold
6
100
Hold at Rate
3.40%
Shares are sold
7
400
Buy
3.40%
Not filled
8
250
Buy
3.35%
Not filled

In this example, orders for 1650 shares of different bid types were placed. The clearing bid or rate is 3.30% because it provided the last share purchase to clear the auction total of 600 shares. All of the orders for bidders 1,2, and 3, totaling 500 shares were filled at the clearing rate of 3.3%. Bidder’s 4’s 200 –share order was partially filled for 100 shares because a maximum of 600 shares available at this auction was reached. The orders for bidders 5 and 6 were sold, because bidder 5 was willing to sell at any rate and bidder 6 was only willing to keep his ARS if the reset rate exceeded 3.4% which it did not so his shares were sold. Existing bondholders/bidders 5 and 6 effectively provided the shares for bidders 1 and 4 (partial) to purchase, while bidders 2 and 3 kept their shares at the new 3.3% reset rate which was the auction’s clearing rate.

ARS Market Has Become More Transparent

In May of 2006 the Securities and Exchange Commission levied fines of $13 million against 15 broker dealers (larger investment banks) for auction practices that were not adequately disclosed to investors, which constituted violations of the securities laws. The violative conduct included, intervening in auctions by bidding for a firm’s proprietary account or asking customers to make or change orders to prevent failed auctions and providing certain customers with information that gave them an advantage over other customers in determining what rate to bid.

In May of this year, The Bond Market Association (TBMA now SIFMA) issued best practices for broker dealers of auction rate securities, addressing issues that arise during auctions as well as any trading between auctions. The Best Practices cover broker dealer obligations to issuers and investors. Issuers should obtain copies of these practices from the BMA web site at http://www.bondmarkets.com/assets/files/Best_Practices_for_Auction_Rate_Secs_%20Exposure_Draft_5-31-06.pdf.

In addition, the TBMA (now SIFMA) has launched new auction rate security indices. TBMA ARS Indices were developed based on recognition by market participants that the unique nature and characteristics of the auction rate market requires distinct benchmarks. It is intended that TBMA ARS Indices will serve as a benchmark for the auction rate market for issuers, investors and swap providers. TBMA ARS indices are similar in concept and approach to the current weekly TBMA Swap Index for tax-exempt Variable Rate Demand Obligation (VDRO’s) Notes (tax-exempt weekly low floaters).

The Indices are published free on a delayed basis on Monday. To ascertain the rate between Thursday and Monday, you need to subscribe with Thomson MMD. See: http://www.bondmarkets.com/story.asp?id=1882

Issuers thinking about using ARS should ask their underwriters and auction agents the extent to which they observe TBMA best practices and, once issued, follow TBMA indices on the reasonability of ARS pricing.

VRDO Vs. ARS

Issuers need to understand how Variable Rate Demand Obligation (VRDO) bonds and Auction Rate Securities (ARS) compare to one another, since these two products account for the overwhelming majority of variable rate municipal debt in the marketplace, with VRDO bonds still doing almost double the volume of ARS. The following table illustrates differences between the two products. Issuers should understand that ARS can only be issued by highly rated borrowers. About 75% of ARS are AAA-rated (typically credit enhanced with bond insurance), 15% are AA-rated, 5% A-rated, and 5% BBB-rated. Almost by definition ARS have to be issued by investment grade obligors. Generally, bond insurers will not put their insurance on less than investment-grade credits (BBB or better). VRDO bonds, on the other hand, are often issued by low or unrated obligors, although the Letters of Credit (LOC) that secures these issues often carry ratings. Unlike bond insurers, LOC banks will credit enhance borrowers with less than investment grade ratings or, in fact, no rating at all in the case of small issue bonds for manufacturers and other borrowers. Therefore, the first thing an obligor needs to determine is whether they have the capability to issue ARS or just VRDO bonds.

Although many types of issuers have issued ARS, typically obligors include: municipalities, utilities, 501 (C)(3) hospitals, housing finance agencies, student loan finance agencies and colleges and universities.

Comparison of VRDO and ARS
Features
VRDO
ARS
Interest rate period
Daily, weekly, monthly, etc. Many are weekly “low-floaters”
7, 28, or 35 days
When interest is paid to bondholders
Monthly or semi-annually
Business day following the auction
Change of interest rate period
Yes
Yes
Credit Enhancement
Typically, a rated bank provides a letter of credit for both credit (pays if borrower does not) and liquidity (to cover any failed remarketing)
Many are insured by AAA-rated bond insurers
All-in Cost (interest rate and fees)
Based on the BMA ARS and swap indices it may be difficult to determine whether VRDO or ARS deliver the lowest base rates—there are significant differences from one week to the next. Fees are higher than ARS, including annual LOC fees) and there are more parties to the transaction than ARS. ARS eliminate LOC renewal risk and the risk of higher annual LOC fees.

Annual broker dealer fees are about 25 basis points, and the Auction Agent fee is 1-2 basis points. No LOC or liquidity facility required but many ARS are insured—bond insurance over the life of an issue is usually less expensive than annual LOC fees.
Long term vs. short term bonds
VRDO are treated as short-term bonds and many require a short-term rating that may cost $5,000 or more per annum.
ARS are considered long-term bonds so there is an upfront rating fee but no annual fee.
Puts and Calls
VRDO holders can put bonds back to the issuer. VRDO issuers can call bonds at par on any interest payment date.
ARS holders do not have the right to put their securities back to the issuer but they can sell them at any auction, if there are buyers. ARS issuers have the right to payoff principal at par on any interest payment date.
Remarketing (interest reset periodically)
Yes, by remarketing agent that costs about 12.5 basis points Yr.
Yes, by auction agent/broker dealer—see above fees.

ARS are a good alternative and complement to fixed rate debt. ARS have advantages and disadvantages relative to VRDO bonds. Issuers need to understand the all-in cost of both ARS and VRDO, taking into account the cost of any credit enhancement. Both ARS and VRDO bonds have traded at a significantly lower rate than fixed rate debt over the past decade. Issuers considering ARS should review the Bond Market Association best practices and indices.

Sources: California Debt and Investment Advisory Commission, Auction Rate Securities, August 2004; Several articles from the Securities Industry and Finance Markets Association (formally the Bond Market Association; PriceWaterhouseCoopers, Investor’s classification of Auction Rate Securities, March, 2005, and The Bond Buyer.


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.

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