Auction rate securities: a primer for finance officers.

• Author: Skarr, Douglas

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...