By Tanya K. Hahn

The fine print clauses in bond documents are generally considered to be in case of never-events. The borrower is not supposed to default. More key in the current situation, the market is not supposed to fail. What could “never happen,” though, is happening. That fine print is now glowing in bright bold letters on the financial agendas of borrowers nationwide.

Depending on the bond structure, borrowing organizations are either being kept up at night by incandescent fine print, or they’re finding it a bright spot to carry them through a dark market.

In particular, borrowers with variable-rate demand bonds (VRDBs) enhanced by a letter of credit (LOC) are lately seeing interest rates and debt service payments increase. Investors may be less willing to buy their bonds, and some borrowers have had their issuances converted to bank bonds as draws are made on their letters of credit.

Ideally, bonds would never fail to be remarketed and cause a draw on the letter of credit. But in the current market, and compared with other financial structures, the letter of credit is holding up and performing as it was intended – as a safety net in case of “never-events.”

You Pay for What You Get
LOC borrowers pay a fee to use a bank’s credit rating when the borrower issues bonds. The enhancement allows the borrower to access capital at a lower interest rate because the bank has promised to pay the investor if the borrower defaults. The investor, then, need not look at the borrower’s credit strength – only at whether it believes the bank is strong enough. The LOC fee also buys backup liquidity support, something that auction-rate bonds, which tanked in February, did not have.

In the much-simplified cycle of bond purchases, a borrower’s debt is structured as bonds, and an investor buys them. Both auction-rate bonds and remarketed LOC-enhanced VRDBs have “put” features: the investors who buy the bonds have the option to put, or sell, the bonds. It is normal for investors to put bonds if they want to restructure their portfolio holdings. What is not normal is for the bonds to fail to find a buyer.

The interest rate on VRDBs is set by a remarketing agent, who places the bonds with an investor at the lowest price s/he can obtain in the market. If an investor no longer wants certain LOC-enhanced VRDBs and puts them, those bonds are remarketed by the remarketing agent. In normal markets another investor usually buys them within the time period specified (e.g. 7 days for weekly resets). If the market goes into a deep freeze as it has over the last few weeks, and the bonds fail to find a buyer in the specified time period, the liquidity backstop is triggered. The bank that issued the LOC is required to purchase the bonds. At this time, the bonds become “bank bonds” and the bank can charge an interest rate as directed by the reimbursement agreement, generally prime plus 1 to 2 percent.

Auction-rate bonds, in contrast, are not remarketed. They are sold at auction to the investor that bids the lowest interest rate. When auction-rate bonds fail (and until recently, they rarely did), investors who want to put the bonds are forced instead to hold them until there is another buyer. Stuck with a hot potato and with no other investors competing to offer the lowest rate in exchange for buying the bonds, the bond investor has the right to charge the borrower the stated maximum interest rate. When the auction-rate bond market blew up, some of these borrowers suddenly found themselves with interest rates of 15 to 20 percent on their debt.

What Happens Now?
Auction-rate bonds are not likely to return as a financing option any time soon. These bonds carried bond insurance as a credit enhancement. Much in the same way that investors look to an LOC bank’s credit strength to gauge the risk in an LOC-enhanced bond, investors look to a bond insurer’s credit strength when deciding whether to bid on an auction-rate bond. Bond insurers, however, have been downgraded or gone under because of their connection to sub-prime mortgages. They are no longer seen as valid backstop measures to protect investors against borrower default.

LOC-enhanced bonds, however, are in only a temporary liquidity rut. The banks and borrowers involved with them are generally still in fairly strong positions, but a skittish overall market sentiment has investors wanting to stay very liquid.

The remarketing agent will continue to try to place the paper even after a remarketing fails, meaning that these bonds have the opportunity to return to the market, thereby paying off the draw on the LOC. For the near term, borrowers will continue to see somewhat higher interest rates on their bonds as either 1) the remarketing agent needs to set the rate higher to entice investors to buy the bonds, or 2) remarketing fails, and the bonds become bank bonds until the markets thaw and remarketing succeeds.

Borrowers with LOC-enhanced VRDBs should understand whether conversion to bank bonds triggers an acceleration feature that could require the borrower to repay its entire loan balance in a compressed time period. Some borrowers may have longer to repay – for example, they may have until the end of the LOC term, which could be three to five years if the enhancement was recently agreed upon. If a borrower faces a very short time period for repayment of a large loan, there may be opportunities to negotiate the repayment period, or even eliminate the acceleration feature.

As the market resettles over the coming months, we anticipate the flow of capital to stabilize, and LOC borrowers to emerge little worse for the wear.

Lancaster Pollard underwrites letter of credit structures, among many other options, and remarkets bonds for both underwriting clients and non-clients. If you have questions about remarketing or about your own structure, please contact Lancaster Pollard at (866) 611-6555.

Print this article