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

• Author: Badach, Keri

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...