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 Thomson Financial. 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 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, variable-rate bonds tied to short-term interest rates. They have a long-term nominal maturity, and interest rates are reset at predetermined intervals--usually seven, 28, or 35 days--using a modified Dutch auction. 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. 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, 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 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 or syndicate of multiple broker/dealers) to structure the issue, underwrite, 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 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. 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 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 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 securities on a pro-rata 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 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 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. 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.