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Short-Term Rates, Long-Term Savings

How debt diversification can help an institution.
University Business, Nov 2007

NOTHING BUT THE BEST and the brightest infrastructure will do for attracting the best and the brightest students. Universities are responding to this competition for students. New technology infrastructure, dorms, and athletic centers are all breaking ground faster than you can say "capital improvement line item." This boost in demand for capital improvements has made it more important than ever for institutional leaders to wisely manage both their debt and equity portfolios.

Colleges and universities have long worked to swell endowment funds by investing equity in the public markets, using balanced, diversified portfolio strategies. Financial service providers are now pushing fund managers to look at debt portfolios as they look at equity portfolios, and to diversify the forms of debt that they use as well. Diversification helps protect portfolios from economic downturns while still benefiting from upturns.

When there is a need for a large-scale capital improvement, universities have an opportunity to reevaluate their school's debt portfolio. Part of this assessment is an analysis of variable rate versus fixed rate bonds. Many consider the use of two variable rate bond products: Auction Rate Securities (ARS) and Variable Rate Demand Bonds (VRDBs).

For universities that have used only fixed rate bonds, considering variable rate bonds is a departure from tradition.

Variable rate bonds have recently been gaining steam with universities.

Variable rate bonds offer the opportunity to lower the cost of capital for longterm capital improvement financing and have some inherent advantages:

Bonds can be a lower-cost source of construction financing, and using them for construction can eliminate the need for an additional construction loan.

Flexible prepayment provisions allow bonds to be redeemed in any amount at any time without a prepayment penalty.

Variable rate bonds typically do not require the substantive initial or ongoing public disclosure to the investment community that is required for long-term fixed rate debt.

By using short-term rates over a long time, variable rate bonds are typically able to deliver lower-cost financing overall. However, variable rate issuers are subject to some additional risks:

The inherent volatility of rates

Bond remarketing risk

Renewal risks posed by credit enhancement and liquidity products.

While variable rate bonds have recently been gaining steam-both in the broader marketplace and with universities-these bonds have been around since the 1980s. The former Glass-Steagall Act legislation, created to regulate the banking industry, contained a loophole that allowed commercial banks to sell certain debt products exclusively for universities and municipalities. This indirectly caused IHEs such as Loyola University of Chicago and University of Chicago to pioneer the use of variable rate bonds. Glass-Steagall was repealed in 1999, but variable rate bonds continue in popularity with educational institutions today.

Debt issuers have become increasingly sophisticated in their ability to manage interest rate exposure, particularly with derivative products. The industry has grown as a result. In 1997, Thompson Financial tracked 91 issues of variable rate bonds in the higher education sector, a number that rose to 139 for 2006. The capital that schools derived from those bonds more than doubled, from approximately $2.02 billion in 1997 to approximately $4.37 billion in 2006.

A variable rate bond is a coupon-paying bond where the coupon interest rate is tied to a common market rate. While the bonds' maturities may vary, the interest rate is set on a short-term basis on regular intervals throughout the term of the bond. Variable rate bonds are issued as long-term bonds, but they are priced and traded as short-term instruments.

There are two main types of variable rate bonds typically used to fund long-term capital improvements by institutions: variable rate demand obligations and auction rate securities. Let's consider each.

VRDOs, also known as "put bonds," are the most popular variable rate bond and the most used by not-for-profit borrowers. They offer a demand, or "put" feature, so bondholders can exercise their put option with seven days notice. The investor can put back the bond to the university at any time. That means a high degree of liquidity is needed. There's no prepayment penalty for paying off these bonds.

Most VRDOs are secured with a bank letter of credit (LOC), although they may only require a liquidity facility. A LOC provides the security of knowing the institution could meet any demands of their bondholders, but there are some strings attached. In a way, the university is "married" to the bank, subject to regular disclosure of finances and "renewal risk."

VRDOs are issued in one of several interest rate "modes" or interest rate reset periods, typically one week, one month, semi-annually, or annually.

The most common, and the one with the most liquid market, is the weekly mode. The VRDO issuer retains a remarketing agent to set the interest rate based on current market conditions each week. This agent sets the interest rate at a sufficient level so that he or she can sell all the bonds into the marketplace. If the demand option is exercised by any of the bondholders, it is the remarketing agent's responsibility to re-offer the bonds to new investors. A considerable amount of control is in the hands of the remarketing agent, so it is important to choose one that is knowledgeable and experienced with VRDOs, and with an extensive distribution system for short-term securities.

A common misconception is that there is one variable rate, but in reality the rate is set by the remarketing agent. Therefore, the rate can vary significantly from agent to agent, depending on sales ability and capital base (or ability to hold unsold securities). While there are industry standard rates, each individual security is priced uniquely. University managers should regularly monitor rates against the market indices to ensure that their remarketing agent is giving their issue the highest degree of sales attention and the best rate.

If an institution is unhappy with the remarketing agent's performance, the agent can be changed. This freedom is the primary protection that a university has to ensure that its bonds will receive the best sales effort.

Using multiple broker-dealers can result in greater financial rewards.

Auction Rate Securities (ARS) are similar to VRDOs in that they are issued in one of several reset intervals, most commonly weekly. As with VRDOs, the interest rate on the bond is adjusted every period. However, ARS do not come with a demand option like the VRDOs. Therefore, with ARS there is no risk of bondholders putting the bonds back to the university-but the university still has the option to call the bonds at any time. With no demand risk, there is no direct requirement for a liquidity facility, giving issuers more choices when considering their approach to backing the bonds.

While demand risk is not present, there is a different risk associated with ARS: auction risk. Auction Rate Securities get their name by the "Dutch auction" process in which they are sold to the marketplace and the interest rate is set.

The role of the broker-dealer for an ARS issuance is similar to that of the role of the remarketing agent for VRDOs, but their methods differ. The auction agent conducts the Dutch auction, in which investors enter a competitive bidding process by submitting a minimum bid rate. The lowest rate at which all bonds can be sold establishes the interest rate, otherwise known as the "clearing rate." A university's credit profile, the perception of its financial standing in the bond-buying marketplace, and the ability of the broker-dealer to attract buyers all affect the success of the auction and the advantageousness of the clearing rate. Therefore, ARS issuers tend to be universities with well-established institutional credit.

An increasing number of higher ed institutions are choosing ARS over VRDOs due to the advantageous pricing. Many schools are even taking the auction process one step further, using multiple broker-dealers to create competition and increase their financial rewards.

Recently, one major private university in the Midwest issued an ARS offering that generated approximately $44 million. The funds will be used to greatly improve its campus, financing the construction of new dorm buildings, a new Biology Department building, and a new Medical Sciences Learning Center, in addition to the renovation and expansion of several other buildings. In this case, the bonds are reset every seven days by a Dutch auction process, in which multiple broker-dealers participate each week, creating a competition that results in lower-cost debt for the school.

Different schools have different financial needs. The defining difference between VRDOs and ARS is the presence of demand risk in the VRDOs and the resulting need for on-demand liquidity. VRDOs are typically more appropriate for universities with a positively evolving credit profile, while ARS are more suitable for well-established universities already displaying indisputable credit and marketplace recognition. Both products can be added to a university's debt mix not just to fund the capital improvement at-hand, but also to diversify the portfolios and use the funds to realize the greatest financial potential.

Jeffrey S. Freese is managing director of public finance for KeyBanc Capital Markets.

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