Variable- and Auction-Rate Securities Dwindle

WASHINGTON — The market for variable-rate demand obligations and auction-rate securities continues to shrink, with outstanding par value of both types of securities tumbling in the 12 months ending in April, according to a report released Tuesday by the Municipal Securities Rulemaking Board.

Outstanding VRDOs totaled $283 billion at the end of April, a decline of 12% from $320 billion in April 2011, and down 17% from $339 billion during the same period in 2010. VRDOs are long-term bonds that function as short-term securities because investors can put them back to the issuer at regular intervals.

Outstanding ARS par fell even further during the 12-month period, falling to $39 billion in April from $55 billion last year, a nearly 30% decline, according to the MSRB. Outstanding ARS par stood at $65 billion in April 2010. ARS are also long-term securities, but their interest rates are reset periodically through auctions.

The MSRB report said early 2012 data indicate that VRDO new-issue volume continues to decline, with new issuance averaging $858 million monthly during the first four months of the year.

If that rate continues, new VRDO issuance in 2012 will reach roughly $10.3 billion, which would be down 27% from last year, when new VRDO issuance totaled $14.2 billion.

Last year’s VRDO issuance, which was down 43% from 2010, was the lowest since 1989. Annual VRDO issuance has fallen every year since an all-time high of nearly $120 billion in 2008.

No new municipal ARS have been issued since December 2007.

Par value of ARS traded also decreased, falling to $26.4 billion in 2011, down 52% from $55.2 billion in 2010. During the first four months of this year, $5.2 billion in ARS par value traded.

Par value of VRDO trades dropped to $1.1 trillion in 2011, down 20% from $1.41 trillion a year ago.

Variable-rate securities have fallen out of favor with investors in recent years.

Before the financial crisis, ARS were an attractive option for municipalities, which could issue the securities without having to purchase a letter of credit from a bank. Broker-dealers were responsible for reselling the bonds to investors.

Starting in early 2008, concern grew among investors about the liquidity of ARS and the viability of insurance firms that backed many of those securities. Also, ARS were risky because they lack the “put” features that are common to VRDOs, meaning investors were unable to send ARS back to the issuer.

As a result, interest rates progressively increased, sometimes hitting caps specified in bond documents. Some issuers found themselves paying interest as high as 12%, said John Hallacy, head of muni research at Bank of America Merrill Lynch.

Soon, auctions run by some of Wall Street’s biggest banks began failing. Many issuers then converted ARSs into VRDOs, causing a spike in VRDO issuance in 2008. The MSRB has collected ARS and VRDO data since 2009 through its Short-Term Obligation Rate Transparency system, and has released annual variable-rate securities reports for three years.




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