Liquidity assessments: an alternative financing option for variable-rate debt.

An environment of volatile and very high interest rates in the late 1970s and early 1980s led to significant innovations in the municipal debt markets that remain operative today For municipal bond investors, volatile interest rates: translated to the risk of severely depressed asset values as long-term rates rose to unprecedented levels. Similarly, issuers of long-term municipal debt struggled with the burden of high debt service costs brought on by the same unstable and high interest rate setting. Based on these factors, variable-rate demand obligations (VRDOs) were developed that allow nominally long-term debt to behave (and be priced) as if it were short-term paper, offering benefits to both investor and issuer.

For investors, the risk of holding long-term bonds subject to steep declines in price if long-term rates increase is mitigated through a demand feature. Also referred to as a "put" or "tender" option, the demand feature allows investors to "put the bond back" (in effect sell it back) to the issuer at predetermined intervals in exchange for receiving par (face value) and accrued interest back from their investment, thereby protecting the principal of their investment. These predetermined intervals, also when interest rates are reset to the current market, can be daily weekly monthly semi-annual, or annual. As a result, VRDOs have the advantage for issuers of being priced as short-term debt instruments, which when issued in the context of a normal upward sloping yield-curve, is less costly. That is to say, a VRDO maturing in 40 years but issued in the weekly mode will be priced as seven-day instruments because investors will always have the option of putting their investment back to the issuer in exchange for par and accrued interest just one week later. Emergence of the VRDO therefore mutually benefits the investor and the issuer. The investor wants to remain invested in the tax-exempt market without exposure to long-term interest rate spikes, and the issuer benefits from borrowing at the short end (and lower interest rate) of the yield curve despite issuing nominally long-term debt.

Since VRDOs were developed in the early 1980s, interest rates have exhibited significantly less volatility and are well below levels of that era. However, use of the VRDO has not diminished and, in fact, has continued to be an attractive alternative for many issuers. According to Thomson Financial, total VRDO issuance grew to more than $65 billion in 2005 from $500 million in 1980.

WHY NOT SIMPLY ISSUE SHORT-TERM COMMERCIAL PAPER?

Corporate issuers typically respond to a dynamic and potentially high long-term interest rate environment by issuing commercial paper (CP) notes--short-term debt instruments with up to 270-day maturity schedules. Public finance issuers are often reticent about reliance on commercial paper or short-term debt to finance infrastructure or long-term assets for many reasons, including the potential for future federal tax law changes. Although commercial paper is frequently also tax-exempt, its relatively short maturity schedule would theoretically render this "grandfathered" tax-exempt status useless once it reached maturity and was roiled over (retired with the proceeds of a new issue of commercial paper) if the law were changed. Moreover, public finance theory supports the notion of issuing debt with a maturity schedule closely aligned with the life of the asset it is financing. If the debt used to finance a capital asset is paid down in rough congruence with the asset's useful life, government revenues (i.e., taxes) used to pay the debt will be generated by users of the asset throughout its life, enhancing taxpayer equity over time.

VRDOS REQUIRE ACCESS TO LIQUIDITY

To accommodate the potential for investors to exercise their put option, VRDOs differ from traditional long-term debt issues in their mechanics and financing participants. To exercise their put option on any interest reset date, investors must notify a tender agent (usually anywhere from one to seven days advance notice is required), who then notifies a remarketing agent, whose role it is to attempt to resell the bonds. It is common for the remarketing agent to be the underwriter (or one of several underwriters) to the VRDO financing itself, which is typically executed through a negotiated sale. If the remarketing agent were unsuccessful in reselling the bonds, they could provide the funds to investors for the put or they could call on the issuer to provide the funds necessary to repay investors principal plus accrued interest. It is due to the latter potential outcome that when issuing VRDOs issuers must demonstrate access to sufficient liquidity to provide funds to meet the demand of investors exercising their put option--which, in theory, could equal the entire amount of the bonds issued. Similar logic applies in the case of tax-exempt commercial paper. If an issuer were unable to sell new commercial paper, the proceeds of which are to be used to retire maturing paper, backup liquidity is necessary to retire the notes.

Several options exist from which issuers can choose to satisfy the need to present to the market capacity to meet repayment requirements of a potential tender of the bonds being issued. Among the most common approaches are lines of credit, letters of credit (LOCs), stand-by bond purchase agreements (SBPAs), and self-liquidity. Because each of these methods of providing liquidity has different attributes, issuers will select the approach that best suits their situation. The various forms of backstop can be viewed as a spectrum, ranging from full irrevocable credit and liquidity support (such as LOCs) to merely providing short-term liquidity support contingent on the issuer maintaining its credit quality (line-of-credit). Of course, the fees for these various instruments are commensurate with the level of support provided. As a result, highly rated issuers will tend to have the luxury of selecting more limited contingent (and cheaper) liquidity support while less highly rated issuers will tend to need to pay up for credit enhancement and liquidity support.

Some highly capitalized and highly rated issuers have the ability to demonstrate that they have sufficient liquidity of their own to meet the repayment requirements of a potential tender. These issuers are able to avoid the fees associated with paying for liquidity facilities while still benefiting from the advantages of issuing VRDOs. Issuers that rely on self-liquidity are also relieved of concerns relating to changes in bank credit ratings, which can impact the rating on the bonds, particularly when the issue is credit enhanced. The disadvantage to utilizing self-liquidity is the limitations it places on the use of its funds so long as the VRDOs remain outstanding. Self-liquidity precludes long-term investment of funds, which may need to be liquidated in as short a time period as one day.

Whatever option is selected, the need for liquidity to be present in the financing is so important that the market convention (requirement) is that issuers obtain a credit rating on the bonds as well as a rating indicating the issuer's liquidity strength. Standard & Poor's Ratings Services expresses these as dual-ratings, (i.e., 'AA/A-I+'), whereby the AN rating is that of the long-term credit while the 'A.-1+' is the liquidity rating.

Line of Credit

When utilizing a line of credit for backup liquidity, the issuer will, for a fee, engage a bank to provide liquidity in the event of a failed remarketing of bonds that have been tendered. Importantly, a line of credit does not enhance the issuer's credit quality, and in fact in the terms of liquidity agreement or revolving credit agreement (RCA) itself, it is common to have provisions allowing the bank to withdraw or terminate its liquidity support if there is deterioration of credit quality by the issuer, as well as other events that permit immediate termination of backup liquidity support. Compared with the other liquidity facilities discussed in this article, lines of credit will provide the weakest support, allowing for more "bank-outs," which are permissible immediate termination events on the part of the banks, than either SBPAs or LOCs. In some weaker lines-of-credit, liquidity support can be withdrawn if the issuer is downgraded at all or to a rating below 'A-' In essence, the bank's liquidity support is only as reliable as the credit quality of the issuer--thus it is "unenhanced." On the other hand, this approach to providing liquidity is a less expensive option than actually purchasing full credit support with an LOC.

Because of the contingent nature (and therefore potential for withdrawal) of this liquidity support when lines of credit are employed, short-term ratings are constrained at the upper end of the spectrum by the issuer's long-term credit rating. To be clear, in order to receive the highest short-term rating ('A-l+'), an issuer must be rated at least 'AA-' or higher. An issuer with a long-term rating of 'A-', for example, will not receive a liquidity rating above 'A-1,' regardless of the liquidity bank's rating. For this reason, "unenhanced" VRDOs and commercial paper will usually be issued by highly rated entities. However, while a high issuer rating is necessary to receive a high liquidity rating, it is not always sufficient. If the liquidity facility includes allowable immediate termination events beyond those that are credit related, the liquidity rating could be lower than the corresponding long-term rating on the issuer theoretically permits, particularly for issuers with long term ratings of 'A' or lower. For an issuer with a long-term rating of 'A,' the short-term liquidity rating could be either 'A-1' or 'A-2,' depending on the strength of the liquidity agreement. Stronger agreements will have fewer allowable immediate termination events relative to weaker agreements.

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