Rate Municipal Securities
Barbara Van Scoy, Principal, CRAFund Advisors
The Community Reinvestment Act (CRA) requires regulated
banks and thrifts to meet the credit needs of their communities. Of the
three performance tests large banks are subject tolending, service
and investmentthe investment test can create the most confusion
as to what constitutes a qualified investment.
Under CRA, an investment qualifies that has as its
primary purpose community development, which means affordable housing,
community services targeted to low- and moderate-income individuals, small
business finance and activities that revitalize or stabilize low- or moderate-income
geographies. This flexible definition allows banks and thrifts to invest
in the communities they serve through creative means rather than dictated
Two instruments that such low-rate municipal securities
may offer a solution. Variable Rate Demand Notes (VRDN) and Auction Rate
Securities (ARS) offer investors short duration assets that have community
development as their purpose.
These liquid securities have been around since the
advent of money market funds in the 1970s, with ARS just recently increasing
in popularity over the past five years. Currently, there are approximately
$120 billion VRDNs and $120 billion ARS outstanding in the marketplace.
These securities have longer maturitiestypically 30 yearsbut
they offer variable interest rate reset periods, usually 7 to 35 days,
resulting in a shorter duration asset.
Variable Rate Demand Note (VRDN)
A Variable Rate Demand Note is a long-term taxable or tax-exempt bond
that bears a floating interest rate and that provides investors the option
to tender or put securities at par on seven days noticeor in some
cases within a day's notice. The bonds tendered are then resold by the
remarketing agent in the secondary market to other investors. VRDNs can
be converted to a long-term fixed-rate security upon appropriate notice
by the issuer.
Also known as Variable Rate Demand Obligations (VRDOs),
these securities are designed to meet the needs of investors requiring
liquidity, flexibility, and competitive short-term rates. The interest
rate resets daily or weekly, depending upon the security. The reset rate
is based on comparable securities with similar maturities and credit ratings,
as well as on supply and demand.
The investor continually earns the market interest
rate because of the reset feature and is guarded against principal loss
because of the par tender feature. Bond holders have the right to tender
their bonds for payment at par plus accrued interest at any time with
appropriate notice to the remarketing agent. In addition, most VRDNs are
highly rated due to credit enhancements, which guarantee the principal
and interest, as well as the liquidity for bonds tendered.
Following are two examples of VRDNs whose primary
purpose is community development:
Weekly Tax-Exempt VRDN (Westchester County, New
The County of Westchester issued industrial development bonds to finance
the acquisition, construction and renovation of Levister Towersa
Section 8 and low income housing tax credit project. The bonds were structured
as a tax-exempt VRDN that will mature August 1, 2033. The security is
rated Aa2/VMIG1 with a letter of credit from the Bank of New York.
Weekly Taxable VRDN (Nevada)
The Nevada Housing Division issued multi-unit housing revenue senior bonds
to finance the acquisition, construction and furnishing of a multifamily
rental housing project. Under the terms of the regulatory agreement, 100
percent of the units will remain available for persons or families with
incomes at or below 60 pecent of the median gross income for the area
at all times during the qualified project period. The taxable security
is rated Aaa with credit support from Fannie Mae. The bond's maturity
is October 15, 2035.
Auction Rate Securities (ARS)
Similar to daily and weekly floaters, Auction Rate Securities (ARS) trade
at par. ARS are sold through a Dutch Auction, which is a competitive bidding
process used to determine rates on each auction date. Bids are submitted
to the auction agent. The winning bid rate is the rate at which the auction
"clears", meaning the lowest possible interest rate that equals
the cumulative total of securities demanded (buyers) to the amount auctioned
New buyers wishing to purchase ARS may submit a bid
at a specified rate on the day of the auction. Holders of the bonds will
be notified of the indicative market rate. All accepted bids receive the
same interest rate.
Owners of ARS have the option to:
- Hold: elect to hold an existing position regardless
of what the new rate might be
- Bid: submit a bid to hold an existing position
at a specified rate
- Sell: request to sell an existing position regardless
of the rate set at the auction
Interest rates are generally reset every 7 or 28
days for taxable issues and every 35 days for tax-exempt issues. Most
ARS pay interest on the business day following the auction; however, some
may have quarterly or semi-annual coupons and trade with accrued interest.
ARS settle on the business day following the auction. There are no liquidations
Following are two examples of ARS whose primary purpose
is community development:
35-day Taxable ARS (Abilene, Texas)
The Abilene Health Facilities Development Corporation financed a loan
to Hendrick Medical Center to help support a family health clinic. This
clinic serves the indigent and provides educational training for nurses
and residents. It is also a member of the Texas Association of Public
and Nonprofit Hospitals, which provides a disproportionate share of uncompensated
healthcare and has an institutional mission that includes a strong commitment
to care for the indigent or needy. In fact, Medicare and Medicaid account
for over 60% percent of gross patient revenues. This security is rated
AAA by S&P with credit support from MBIA and matures September 22,
28-day ARS Private Placement (San Diego, California)
The San Diego Family Housing, LLC issued military housing revenue obligations
to help provide housing for lower-pay grade enlisted personnel. Pursuant
to a lease by the United States Navy, the notes finance a portion of the
acquisition, construction, and renovation of housing units at 20 different
properties in San Diego amounting to a total of approximately 3,200 units.
Both existing and proposed housing units are targeted at personnel earning
below 80 percent of median family income (for San Diego County, the 2003
HUD median family income is $59,900). This security is rated AAA by S&P
with credit support from MBIA, a municipal bond insurance company. It
is a private placement, maturing July 1, 2035.
Many banks invest solely in taxable or bank-qualified municipal securities,
rather than tax-exempt securities. While there are taxable variable rate
demand notes, the market is considerably smaller. Given the current interest
rate environment, the spread between taxable and tax-exempt floating rate
securities allows taxable investors a wider array of potential community
development investments with only a small sacrifice in yield.
Variable Rate Demand Notes and Auction Rate Securities
offer investors the opportunity to invest in short duration assets that
have community development as their primary purpose. These securities
are an attractive option for investors that help satisfy CRA requirements,
while mitigating interest rate risk.
Barbara Rose VanScoy
Rose VanScoy is a principal at CRAFund Advisors, the registered investment
advisor for the CRA Qualified Investment Fund. Ms. VanScoy is responsible
for researching and documenting qualified investments on behalf of the
CRA Qualified Investment Fund's shareholders. Prior to joining CRAFund
Advisors, Ms. VanScoy was the director of research at SunCoast Capital
Group. While there, she also headed SunCoast's Community Development Initiative,
in which she assisted their depository clients with community development
investing. Ms. VanScoy was previously employed with Raymond James Tax
Credit Funds as the director of debt placement, and as a vice president
in fixed income research. She is a graduate of the University of Florida
with a BSBA in finance, and a specialization in Latin American studies.
She can be reached through CRAFund Advisors at 877/272-1977 or directly