The Quiet Corner of Dutch Auctions

Last April, when Google Inc. unveiled its plan to use a Dutch style auction in its initial public offering, it brought the popularity of this peculiar way of setting securities prices to a new height. Meanwhile, a sea change has been taking place for several years that promises to redefine how debt issuers tap the short-term fixed income market. Due to limited public awareness of the potential risks involved, this quiet storm may catch an unsuspecting corporate cash manager by surprise.

The New “Dutch” Twist

The new trend involves long-term variable rate debt securities, generally referred to as auction rate securities (ARS), that are being resold to investors at short intervals using the Dutch auction to reset interim interest rates. The short auction cycle, typically every 28 days, allows the securities to behave like money market instruments with competitive yields.
The new “Dutch” twist is the serial nature of the auctions that effectively turns a long-term bond into a money market instrument with built-in renewal features. In addition to allowing bond issuers to pay short-term interest rates on long maturity securities, the structure saves issuers the additional expenses of retiring old debt with new offerings.
The securities’ lack of a “demand” feature, or an agreement that allows investors to sell them at face value at any time, is a main risk concern for corporate cash investors. While ARS generally offer higher yield than the average money market fund, corporate treasurers should carefully consider the impact of the potential lost use of the company’s cash balances when an auction fails.
Money market mutual funds, under a 2a7 rule of the Securities and Exchange Commission, are barred from purchasing ARS due to the securities’ long stated final maturities, typically at 30 years.

The Torrid Growth of the ARS Market

Corporate cash accounts only recently replaced wealthy individuals as the largest group of buyers of ARS, followed by other retail brokerage accounts and institutional investors. Despite almost nonexistent public awareness, the explosive growth of the market in recent years is nothing short of spectacular.
According to data from Deutsche Bank at a 2004 Florida conference for municipal issuers, the ARS market doubled between the first quarter of 2002 and the end of 2003, with total outstanding debt increasing from $103 billion to $204 billion. By comparison, total treasury bills and commercial paper outstanding in 2003 were $928 billion and $1.28 trillion, respectively, according to the Bond Market Association. In particular, ARS bonds backed by municipal projects, both taxable and tax exempt, almost tripled, to $72 billion in the same period. Judging from recently announced deals, the trend shows no sign of slowing down.
Among the main driving forces of the ARS growth are the low interest rate environment and the rapid growth of consolidation student loans.
Compared to an approximately 1% yield on most large institutional money market funds, ARS typically offer 15 to 20 basis points in additional yield. For corporate accounts that attempt to maximize earnings power without taking on additional interest rate risk, this small margin still offers relative yield advantage over other cash management alternatives, such as corporate commercial paper.
On the supply side, a big push comes from asset backed issuers and the broker-dealer community to securitize the mammoth growth of student loans when cash investors are either unfamiliar or unconcerned with the liquidity and credit concerns of ARS investments.
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