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UNDERWRITING BASICS

An underwriter is a securities dealer who helps government entities bring bond issues to market. The key role it plays is to buy the bonds from the issuer and then resell them to investors. In doing so it assumes a financial risk and thus expects to make a profit on the transaction.

The difference between the purchase price paid by the underwriter to the issuer and the price at which the bonds are resold to investors represents the underwriter's profit or discount. The underwriter's discount depends on factors such as the interest rate and accurate pricing of the bonds. If the market rate of interest moves against the underwriter after the sale, the underwriter's profit will be lower than expected. Conversely, if the market rate of interest moves in favor of the underwriter, the underwriter's profit will be higher.

An underwriter may be independent or part of a securities firm or bank. Often, securities firms and banks have municipal bond departments that carry out functions such as underwriting, marketing or trading municipal securities.

Municipal bond underwriting is one of the functions performed by investment banks, which also underwrite corporate stock and bond offerings and advise companies on mergers and acquisitions. Investment banks do not disclose exactly how much of their revenues derive from muni underwriting, but they have certainly benefited from the rise in recent years in the volume of new municipal issuance, which reached an all time high of $379.1 billion in 2003. This comprised one-fifth of the total of $2 trillion in new securities (municipal and corporate) issued during the year.
 

TYPES OF SALES AND THE PROCESS OF UNDERWRITING

The two most common ways of issuing debt through bonds by state and local governments are by competitive bidding or by negotiated sales. In both kinds of sales, the underwriters work closely with traders and sales persons to determine the price of a new issue.

New issues of municipal bonds are sometimes sold through private placements. In private placements, issuers may sell the bonds directly to investors or through a placement agent.

State and local statutes may have restrictions on the type of sale allowed by localities. For example, general obligation bonds are often required by law to be sold competitively.

Both types of sales can also be done by a syndicate, that is, a group of underwriters comprising a lead manager and co-managers. Syndicates include underwriters from competing firms who agree to bid together for an issue. The syndicate determines the pricing and distribution of the issue. The lead manager is responsible for coordinating the deal.

For both competitive and negotiated sales, there are often requirements related to advertising the sale of the bonds and the circulation of a disclosure document.

Competitive Sales

In a competitive sale, underwriters submit a sealed bid for purchasing the bonds to the issuer at a specific time on a specified date. In this system, there will normally be more than one bidder. The bidder offering the lowest true interest cost to the issuer (i.e., interest cost that takes into account the time value of money) will be awarded the bid.

If the competitive bid involves a syndicate, the syndicate's bid must meet all the published requirements of the issue and arrange for a good faith deposit if that is required. The winning bid becomes the contract of sale for the offering. After the syndicate purchases the bonds, it resells them to retail investors. The underwriter essentially acts as the intermediary between the issuer and the initial investor. A competitive sale is also called an advertised sale or a sealed bid sale.

In a competitive bid or sale, once the issuer has structured an offering and completed relevant legal, financial and other tasks, an official notice of sale that serves as the advertising document is usually published in the Bond Buyer, the national trade newspaper of the industry and in other national and local publications. Legal requirements for advertising at the local level often pertain to matters such as a specified time frame in which the bonds or notes must be advertised prior to a sale.

Notice of the sale is also sent out to potential bidders. The notice of sale includes information such as the amount of debt or bonds being issued, the structure of the deal, the type of debt or bonds, the time and place of sale, the name of the counsel and bidding specifications.

In addition, full disclosure requirements stipulate that information on the potential risk to investors be provided through documents such as an official statement. The Government Finance Officers Association provides guidelines for disclosure, though as a largely unregulated over the counter market, there are no specific disclosure requirements for bonds sold through this system.

Negotiated Sales

In a negotiated sale, the issuer selects the underwriter (or underwriters in the case of a syndicate) prior to the public sale date. The issuer may select co-managers from competing firms to work as part of a syndicate. The lead underwriter or manager coordinates the deal.

The first step in a negotiated sale is a Request for Proposals (RFP) that is sent out by the issuer to selected underwriters. The RFP specifies the selection criteria that form the basis of evaluating the proposals/responses that will be submitted by the underwriters in response to the RFP.

Among other things, an RFP will request information on the firm's experience with underwriting the type of issue being considered, resumes of key personnel and their time commitment for the proposed issuance, management fees and estimated expenses, list of anticipated services, and preliminary ideas about the structure of the deal.

The selection process also involves interviews of key players, such as public investment bankers and underwriters, who have to defend their proposed roles and strategies in planning and executing the deal. 

The underwriter selected in a negotiated sale has the exclusive right to purchase the bonds at agreed upon prices.

The managers set a preliminary pricing schedule that may be revised upward or downward. They may also set a final price on the day of the sale.

The managers in a negotiated sale will make an offer to purchase the bonds from the issuer at a price that will incur the lowest interest cost for the issuer but at the same time be salable to investors. Negotiated sales may be more cost effective if the issuer has the necessary expertise to negotiate with underwriters. A negotiated sale can be a cooperative effort between the issuer and the underwriter for structuring a deal with reasonable terms.

Private Placements

Private placements are direct transactions between the issuer and investors, i.e., the bonds are sold directly by the issuer to investors without an underwriter. In this process, instead of underwriters, placement agents act as intermediaries between the issuer and investors. However, they do not assume any underwriting risks. In recent years, some issuers have bypassed placement agents and have done private placements directly with ultimate investors. This kind of private placement is called a direct purchase.

The Relative Advantages and Disadvantages of Each Type of Sale

Even if there are no requirements relating to state or local statutes governing the sale of bonds, one type of sale may be preferred over others depending on the kind of transaction. Issuers usually choose one method over the others based on which will yield the lowest all-in borrowing cost.

Proponents of competitive sales argue that in this type of sale underwriters offer the most competitive or lowest prices in order to increase their probability of winning the bid. Since this kind of bidding process is open to all underwriters and the lowest price serves as the only criterion for awarding the bid, it is a fairer method that is better able to avoid allegations of preferential treatment.

Competitive sales, however, often work to the advantage of better-known established underwriters with higher credit ratings. Competitive bids are also favored for deals with simple bond structures or when the security is strong and predictable, as in the case of general obligation bonds.

On the other hand, proponents of negotiated sales argue that this type of transaction works better and results in lower borrowing costs because it allows for more flexibility in timing sales, provides more information to investors, gives the opportunity for pre-marketing, and is able to better customize structures and maturities for targeted investors. Negotiated sales tend to work better when the bond issue is more complex and the underwriters are not as well established.

An issuer may prefer a private placement if it does not have an established credit history, or if the bonds issued is of lower grade. Private placements are often preferred by issuers because financial and other information about the issuer is disclosed to direct investors only and not disseminated to the public or competitors.
 

ISSUES IN THE MUNICIPAL BOND UNDERWRITING BUSINESS

Aside from issues of cost, there are political considerations. Negotiated sales create a possibility for underwriters to use campaign contributions and connections to obtain deals on terms that may not be in the best interest of the public.    

Concerns about influence-peddling were at the center of investigations of the bond market conducted by the Securities and Exchange Commission  in the early 1990s. The investigations involved a range of issues, including:

  • Pay-to-play (through which underwriting firms make political contributions to get underwriting deals)
  • Conflicts of interest (whether persons associated with municipal issuers have relations with underwriting firms)
  • Inadequate disclosure
  • Lack of price transparency and excessive markups in bond prices
  • Questionable sales practices

In its initial information seeking efforts, the SEC found that most firms made significant political contributions and that those that were making contributions were usually the same ones that were seeking municipal business.

Scandals over political contributions and influence peddling involving high-level officials at leading securities firm led executives representing 17 Wall Street firms to call for a voluntary ban on political contributions by their municipal bond departments in October 1993. Together, the 17 firms represented approximately 75 percent of the municipal underwriting business. The announcement was made just before the municipal market's main self-regulatory group, the Municipal Securities Rulemaking Board (MSRB), proposed a rule to limit the growth of business-related contributions by Wall Street firms. In April 1994, the MSRB passed Rule G-37, which barred municipal dealers that made political contributions to clients from doing business with those clients for the next two years. MSRB's Rule G-37 was, however, less strict than the voluntary ban.

For more on MSRB rules regarding these issues see section on Regulation of municipal bonds.

For more on political contributions, see the Overview of Leading Underwriters.


Updated: June 2004

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