Auction rate securities: a primer for finance officers.The auction rate securities market has expanded significantly in the public finance sector since 2001. Nationwide, issuance of auction rate securities, including the public finance sector, grew from $100 billion in the first quarter of 2002 to $200 billion by the end of the fourth quarter of 2003. Municipal issuers sold $42.8 billion of auction rate securities in 2004 compared with $41.3 billion in 2003, according to according to prep. 1. As stated or indicated by; on the authority of: according to historians. 2. In keeping with: according to instructions. 3. Thomson Financial Thomson Financial A major provider of information, analytical tools, and consulting services to the financial community. The firm, a division of Thomson Corporation, is best known to investors for its First Call segment, which publishes consensus earnings . Public finance has become the fastest-growing sector to use auction rate securities, with total issuance projected to grow at double-digit rates in the future. The use of auction rate financing is becoming more attractive for many reasons, especially in comparison to variable rate demand obligations. Auction rate securities have no "put" or tender feature, no letter-of-credit requirement, and no need for an annual short-term Short-term Any investments with a maturity of one year or less. short-term 1. Of or relating to a gain or loss on the value of an asset that has been held less than a specified period of time. bond rating, all of which increase the cost of issuing and managing variable rate demand obligations. However, auction rate securities may not be appropriate for all municipal issuers. Municipalities planning to issue auction rate securities must carefully evaluate the current environment and their objectives, and consider how this debt will be managed over the long term. This article provides an overview of the market, mechanics, costs, benefits, and risks associated with auction rate securities. AUCTION RATE SECURITIES EXPLAINED Auction rate securities are long-term Long-term Three or more years. In the context of accounting, more than 1 year. long-term 1. Of or relating to a gain or loss in the value of a security that has been held over a specific length of time. Compare short-term. , variable-rate Variable-rate A varible-rate agreement, as distinguished from a fixed-rate agreement, calls for an interest rate that may fluctuate over the life of the loan. The rate is often tied to an index that reflects changes in market rates of interest. bonds tied to short-term interest rates Short-term interest rates Interest rates on loan contracts-or debt instruments such as Treasury bills, bank certificates of deposit or commerical paper-having maturities of less than one year. Often called money market rates. . They have a long-term nominal maturity, and interest rates are reset at predetermined pre·de·ter·mine v. pre·de·ter·mined, pre·de·ter·min·ing, pre·de·ter·mines v.tr. 1. To determine, decide, or establish in advance: intervals--usually seven, 28, or 35 days--using a modified Dutch auction Dutch Auction An auction where the price on an item is lowered until it gets its first bid, and then the item is sold at that price. Notes: The U.S. Treasury (and other countries) uses a Dutch auction when it sells securities. . They trade at par and are callable Callable Applies mainly to convertible securities. Redeemable by the issuer before the scheduled maturity under specific conditions and at a stated price, which usually begins at a premium to par and declines annually. 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. Auction rate securities typically include a "multi-modal" conversion feature that allows for conversion to long-term fixed- or variable-rate bonds. The usual minimum issue size is $25 million, in denominations of $25,000. Although auction rate securities are issued and rated as long-term bonds (20 to 30 years), they are priced and traded as short-term instruments because of the liquidity provided through the interest rate reset mechanism. Frequent issuers of municipal auction rate securities include traditional issuers of tax-exempt debt such as municipalities, non-profit hospitals A non-profit hospital, or not-for-profit hospital, is a hospital which is organized as a non-profit corporation. Based on their charitable purpose and most often affiliated with a religious denomination they are a traditional means of delivering medical care in the United States. , utilities, housing finance agencies, student loan finance authorities, and universities. Municipal issues are typically of high credit quality. Historically, more than 75 percent of the issues sold have received the highest credit rating available from the major credit agencies, generally because of bond insurance. Investors in auction rate securities are typically high net worth individuals (for tax-exempt issues) or corporations (for taxable issues). Money market funds are ineligible in·el·i·gi·ble adj. 1. Disqualified by law, rule, or provision: ineligible to run for office; ineligible for health benefits. 2. to hold auction rate securities because of Securities and Exchange Commission Rule 2a-7, which limits them to securities with a final maturity of 397 days or less. In addition to the typical participants in a municipal bond issue, auction rate securities require a broker/dealer (either a single underwriter underwriter n. a company or person which/who underwrites an insurance policy, issue of corporate securities, business, or project. (See: underwrite) UNDERWRITER, insurances. One who signs a policy of insurance, by which he becomes an insurer. or syndicate Syndicate organized crime unit throughout major cities of the United States. [Am. Hist.: NCE, 2018] See : Gangsterism of multiple broker/dealers) to structure the issue, underwrite To insure; to sell an issue of stocks and bonds or to guarantee the purchase of unsold stocks and bonds after a public issue. The word underwrite has two meanings. , distribute, and provide and increase liquidity to investors. Auction rate securities also require an "auction agent" to receive bids from the broker/dealers, determine the winning bid and reset rate, and act as liaison among the issuer, brokers, trustees, and security depositors. Auction rate securities carry the typical upfront fees associated with a fixed-rate bond issuance, along with ongoing maintenance fees. Industry standard is $5 per bond for the initial placement fee plus annual fees of 25 basis points for broker/dealer fees and 1 to 2 basis points for auction agent fees. Because auction rate securities have no letter of credit requirement, there are no letter of credit fees. However, additional costs for bond insurance may be necessary. Credit risk associated with auction rate securities mirror those of other municipal and corporate issues in terms of default risk associated with the issuer. Because they do not carry a "put" feature (which allows the bondholder Bondholder A firm often has stockholders and bondholders. In a liquidation, the bondholders have first priority. bondholder An individual or institution that owns bonds in a corporation or other organization. to require the purchase of the bonds by the issuer or by a specified third party), auction rate securities are very sensitive to changes in credit ratings and normally require the highest ratings to make them marketable Marketable are securities that can be easily converted into cash. Such securities will generally have highly liquid markets allowing the security to be sold at a reasonable price very quickly. . This is usually achieved with bond insurance. DUTCH AUCTION MECHANICS The interest rate on auction rate securities is determined through a Dutch auction process. The total number of shares available to auction at any given period is determined by the number of existing bondholders who wish to sell or hold bonds only at a minimum yield. Existing bondholders and potential investors enter a competitive bidding Competitive bidding A securities offering process in which securities firms submit competing bids to the issuer for the securities the issuer wishes to sell. competitive bidding 1. process through broker/dealers. Buyers specify the number of shares, in denominations of $25,000, they wish to purchase with the lowest interest rate they are willing to accept. Each bid and order size is ranked from lowest to highest minimum bid rate. The lowest bid rate at which all the shares can be sold at par establishes the interest rate, otherwise known as the "clearing rate." This rate is paid on the entire issue for the upcoming period. Investors who bid a minimum rate above the clearing rate receive no bonds, while those whose minimum bid rates were at or below the clearing rate receive the clearing rate for the next period. Holders of existing auction rate securities have the option to: * Hold at market--hold an existing position regardless of the new interest rate (these shares are not included in auction). * Hold at rate--bid to hold an existing position at a specified minimum rate. * Sell--request to sell an existing position regardless of the interest rate set at the auction. Potential buyers have the option to: * Buy--submit a bid to buy a new position at a specified minimum interest rate (new buyers or existing bondholders adding to their position at a specified interest rate). Exhibit 1 illustrates how the clearing rate is determined for an offering of 500 shares, made up of orders to sell and orders to hold at rate. In this example, orders for 1,300 shares of different bid types were placed. The clearing bid is 1 percent because it provided the last share purchase to clear the auction total of 500 shares. The entire orders for Bidders 1, 2, and 3, totaling 400 shares, were filled at the clearing rate of 1 percent. Bidder 4's 200-share order was partially filled for 100 shares because a maximum of 500 shares available at this auction was reached. The orders for Bidders 5 and 6 were sold. Bidders 7 and 8 had buy orders that were not filled. The following are the steps in the auction process, as illustrated in Exhibit 2: * Investors specify the par amount of securities they want and what they are willing to pay * The broker/dealer(s) convey the bids to the auction agent * The auction agent, who is a third-party bank selected by the issuer, collects all the bids from all participating broker/dealer(s) on behalf of the investors * The auction agent assembles all the bids in ascending ascending /as·cend·ing/ (ah-send´ing) having an upward course. ascending progressing to higher levels, usually used in reference to the nervous system. rate order and determines the clearing rate * The bids at or lower than the clearing rate will receive the bonds. If there are multiple bids at the clearing rate, the auction agent will allocate To reserve a resource such as memory or disk. See memory allocation. securities on a pro-rata Pro-rata Used to describe a proportionate allocation. Notes: For example, a pro-rata dividend means that every shareholder gets an equal proportion for each share they own. See also: Dividend basis. Existing bondholders receive preference over new bidders at the same rate * After selection, the auction agent notifies the broker/dealer(s) of the auction results * The broker/dealer(s) record and settle the trades for next business day settlement A "failed auction" can occur due to a lack of demand and no clearing bid received. In the event of a failed auction, existing bondholders will hold their positions at the maximum rate set in the official statement until sufficient bids are entered to set a clearing bid at the next auction. Although the underwriting Underwriting 1. The process by which investment bankers raise investment capital from investors on behalf of corporations and governments that are issuing securities (both equity and debt). 2. The process of issuing insurance policies. broker/dealers are not required to do so, they can provide a "clearing bid" to ensure the success of each auction and provide liquidity to investors who wish to sell. Failed auctions are very rare and are associated with downgrades in credit quality of either the issuer or the insurer An individual or company who, through a contractual agreement, undertakes to compensate specified losses, liability, or damages incurred by another individual. An insurer is frequently an insurance company and is also known as an underwriter. of the issue. For auction periods with a lack of supply, meaning all existing bondholders wish to continue to hold, an "all hold" rate is paid for the next period. This rate is established in the official statement and is generally tied to the Bond Market Association Index rates or commercial paper rates. Interest is paid by a trustee or paying agent Paying Agent An agent who accepts payments from the issuer of a security and then distributes the payments to the holders of the security. Also known as a "disbursing agent. . Interest payments to bondholders in the current month will be based on the interest rate determined in the prior month's auction period. This lag time is necessary to provide time for clearing and administration of the payments. COMPARISON TO VARIABLE RATE DEMAND OBLIGATIONS Auction rate securities are an alternative to variable rate demand obligation bonds. A variable rate demand obligation is a security for which the interest rate is reset periodically, typically through a remarketing process, or according to a specified index. The bond's demand feature permits the bondholder to require the purchase of the bonds by the issuer or by a specified third party, either periodically, at a certain time prior to maturity, or upon the occurrence of specified events or conditions. This process is often referred to as "putting" a bond or exercising a tender option. Interest rates are generally based on market conditions and the length of time until the bondholder can exercise the put option. Because of the put feature, the variable rate demand obligation normally requires a bank letter of credit. Whereas a variable rate demand obligation would generally require a letter of credit, auction rate securities do not because the investor does not possess a put option but rather relies on the liquidity generated by the Dutch auction process and the credit worthiness of the issuer or insurer. Although no letter of credit is required, most issues carry bond insurance to elevate el·e·vate tr.v. ele·vat·ed, ele·vat·ing, ele·vates 1. To move (something) to a higher place or position from a lower one; lift. 2. To increase the amplitude, intensity, or volume of. 3. them to the highest credit rating. Exhibit 3 compares auction rate securities to variable rate demand obligations. The interest rate on auction rate securities is usually slightly higher than that of variable rate demand obligations, which generally results in a higher cost of funds Cost of Funds The interest rate paid on an outstanding loan. Notes: Money isn't free! Cost of funds is the cost of borrowing money. See also: Interest Rate Cost of funds Interest rate associated with borrowing money. for the borrower. In addition, the upfront fee (initial placement fee) associated with auction rate securities is generally higher than that of variable rate demand obligation bonds. However, the cost of obtaining a letter of credit, along with the risks associated with the elimination and/or renewals of the letter of credit, can make the cost of funds for an issuance of variable rate demand obligations on par with or even more expensive than an issuance of auction rate securities. KEY CONSIDERATIONS Before issuing auction rate securities, governments need to carefully weigh the benefits and risks. Below are the key issues to consider. Lower Interest Costs. Over the past 10 years (through 2004) the spread between long-term (fixed) and short-term (variable) debt has been significant. In 2004, for example, the spread between The Bond Buyer 20-Year GO Index (fixed-rate average) and The Bond Market Association Swap Index (variable-rate average) was about 3.5 percent. Higher Risk. Auction rate securities are long-term variable-rate debt with interest payments determined on a seven-, 28-, or 35-day basis. In periods of sustained rising rates, interest expense and volatility will rise. Issuers must be aware of the potential impact rapidly rising rates will have on forecasted debt service and cash needs. Depending on the issuer's tolerance for risk, it may require supplemental hedging strategies to mitigate mit·i·gate v. To moderate in force or intensity. mit  i·ga tion n. the variability of interest
rates. Issuers employ a variety of mechanisms to lower or eliminate
interest rate risk and volatility. The most common are interest rate
caps and interest rate swaps Interest Rate SwapA deal between banks or companies where borrowers switch floating-rate loans for fixed rate loans in another country. These can be either the same or different currencies. . An interest rate cap is used when a variable rate bond issuer enters into a contract with a counterparty Counterparty The other participant, including intermediaries, in a swap or contract. (typically a financial institution) to maintain interest rate payments within pre-established limits. In effect, the bond issuer is buying an insurance policy to protect it against high interest rate payments on its variable rate bonds. The counterparty takes the obligation to pay rates above the cap level. Many variable rate issuers use interest rate swaps to hedge their interest rate risk. Interest rate swaps permit borrowers to convert variable-rate cash flows into fixed-rate cash flows without changing the structure of the underlying bond issue. Variable-rate borrowers who want to fix borrowing costs pay a fixed amount to the financial institution, which in turn pays a floating amount to the borrower to settle the underlying variable-rate loan Variable-rate loan Loan made at an interest rate that fluctuates depending on a base interest rate, such as the prime rate or LIBOR. obligations. Variable Rate Debt Ratio. Some rating agencies recommend that variable-rate debt not exceed 20 percent of total debt outstanding. In reality, there are many factors that affect the appropriate level of variable-rate debt for a particular issuer. Governments should consider the use of auction rate securities in light of their existing debt burden, risk tolerance Risk Tolerance The degree of uncertainty that an investor can handle in regards to a negative change in the value of their portfolio. Notes: An investor's risk tolerance varies according to age, income requirements, financial goals, etc. , and financial policies. GFOA GFOA Government Finance Officers Association Guidelines guidelines, n.pl a set of standards, criteria, or specifications to be used or followed in the performance of certain tasks. . GFOA has a recommended practice on the issuance of variable-rate debt. This guidance applies to auction rate securities, as well as variable-rate demand obligation variable-rate demand obligation A floating-rate debt obligation that has a nominal long-term maturity as well as an option allowing the investor to put (sell) the obligation back to the trustee, generally at par plus accrued interest. bonds or any other variable-rate debt instruments. The recommended practice offers the following guidance: * Review statutes or ordinances governing gov·ern v. gov·erned, gov·ern·ing, gov·erns v.tr. 1. To make and administer the public policy and affairs of; exercise sovereign authority in. 2. the issuance of debt to ensure that the issuance of auction rate securities is permitted and understood * Ensure that the government's debt policy specifically addresses the use of auction rate securities * Consider the ability of the government to manage auction rate securities, including staff requirements to monitor market conditions; record interest rate changes; make adjustments to budgets and financial plans as needed as needed prn. See prn order. ; and manage relationships with investors, liquidity providers, and remarketing agents * Evaluate the impact on debt service requirements assuming different interest rate scenarios and develop appropriate contingency plans A plan involving suitable backups, immediate actions and longer term measures for responding to computer emergencies such as attacks or accidental disasters. Contingency plans are part of business resumption planning. for rising interest rates * Consider the impact of changing interest rates on rate covenants Rate covenant A provision governing a municipal revenue project financed by a revenue bond issue, which establishes the rates to be charged users of the new facility. rate covenant and an issuer's financial position * Evaluate the total cost of issuing auction rate securities, including fees to brokers, auction agents and trustees, bond insurance costs, additional internal resource needs, and possible use of derivative instruments Derivative instruments Contracts such as options and futures whose price is derived from the price of an underlying financial asset. such as interest rate caps and swaps CONCLUSION Auction rate securities can be a valuable alternative and complement to fixed-rate debt in a government borrowing program. Governmental issuers considering issuing auction rate securities must carefully evaluate their objectives and how this debt will be managed over the long term. Issuance of auction rate securities 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 auction rate securities offers a number of potential benefits, such as reducing total interest costs, diversifying the debt portfolio, allowing the opportunity to take advantage of short-term variable-rate trends, and matching the structure of assets to liabilities. However, auction rate securities carry more risk than fixed-rate bonds. These risks can be offset with the appropriate use of derivative derivative: see calculus. derivative In mathematics, a fundamental concept of differential calculus representing the instantaneous rate of change of a function. products like interest rate caps and variable-to-fixed interest rate swaps. Like other variable-rate debt instruments, auction rate securities require a greater commitment of time and expertise by staff. 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 Credit Rating Agencies Firms that compile information on and issue public credit ratings for a large number of companies. . The author thanks Shafiq Jadavji, vice president of Deutsche Bank Deutsche Bank AG (IPA: /'dɔɪ.tʃə/[1]) (ISIN: DE0005140008, NYSE: DB) (English: German Bank Trust Company Americas, for his input to this article. DOUGLAS SKARR is a research program specialist with the California California (kăl'ĭfôr`nyə), most populous state in the United States, located in the Far West; bordered by Oregon (N), Nevada and, across the Colorado River, Arizona (E), Mexico (S), and the Pacific Ocean (W). Debt and Investment Advisory Commission.
Exhibit 1: Example of Sales Process
$25,000,000 ARS Issue
Outstanding 1,000 shares @ $25,000 each; available 500 shares
(includes all sell and hold at rate orders)
Order Bid Orders Filled
Placed Minimum @ 1.00%
Bidder Shares Bid Type Rate (clearing rate)
1 100 Buy Any 100
2 200 Hold at Rate 0.90% 200
3 100 Hold at Rate 0.95% 100
4 200 Buy 1.00% 100 (Partial)
5 100 Sell Any Shares are Sold
6 100 Hold at Rate 1.03% Shares are Sold
2 300 Buy 1.03% Not Filled
8 200 Buy 1.10% Not Filled
Exhibit 3: ARS vs. VRDO
VRDO ARS
Denominations $100,000 $25,000
(Tax-exempt)
$50,000 (Taxable)
Interest Rate Daily, weekly, 7 day (Non-AMT),
Period monthly, etc. 28 day (Taxable),
35 day (AMT)
Interest Payment Monthly or Business day
Rate semi-annually following the auction
Rate Period Yes Yes
Rate Period
Insurance Must at least Typically insured
have a liquidity
facility
Credit AA/Aa or better AAA/Aaa
Enhancement plus liquidity
Remarketing Yes Broker/dealer
Tender or "Put" Yes No (subject to
mandatory purchase
on conversion date
to another mode)
Redemption Callable on any Callable on any
Provisions interest payment interest payment
date at par value date at par value
Typical Investor Mainly money Corporate and high
market funds, net worth
corporate investors, bond
investors, high net funds, and bank
worth investors trust departments
to a lesser extent
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