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Weekly UpdatesWhereas 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 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 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 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.
An interest rate cap is used when a variable rate bond issuer enters into a contract with a counterparty (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 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, and financial policies.
GFOA Guidelines. 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 bonds or any other variable-rate debt instruments. The recommended practice offers the following guidance:
* Review statutes or ordinances governing 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; 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 for rising interest rates
* Consider the impact of changing interest rates on rate covenants 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 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 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.
The author thanks Shafiq Jadavji, vice president of Deutsche Bank Trust Company Americas, for his input to this article.
DOUGLAS SKARR is a research program specialist with the California Debt and Investment Advisory Commission.
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