As discussed earlier, underwriters are financial institutions that sell new-issue securities to investors on behalf of issuers. Many underwriting efforts for corporate securities are similar, which we’ll cover in depth later in the primary market chapter. This section focuses on what’s unique about underwriting a municipal security.
Continue with the earlier example: a city wants to raise $100 million to build a new high school. This time, we’ll look at the process from the underwriter’s perspective.
You already know about the Bond Buyer, an online publication primarily read by municipal underwriters looking for potential business. When a firm like Bank of America (the largest municipal underwriter) is looking for underwriting opportunities, it may start by reviewing the Bond Buyer.
Underwriters look for municipalities selling bonds that they believe will be marketable to their customers. When an underwriter sees the Official Notice of Sale for the $100 million high school bond, multiple underwriters may be interested. Before submitting a bid, the underwriter will typically review market statistics.
The Bond Buyer publishes several municipal bond indexes and a yield curve. The S&P 500 is an index that tracks the stock values of 500 large domestically traded equity securities. Bond indexes serve a similar purpose, but they focus on bonds and generally track yields rather than stock prices. The municipal bond indexes and yield curve included in the Bond Buyer are:
Revdex (25 bond index)
Bond Buyer index (40 bond index)
Bond Buyer 20 (20 bond index)
Bond Buyer 11 (11 bond index)
SIFMA Index
Municipal Market Data (MMD) yield curve
These indexes give underwriters a snapshot of the municipal bond market. Before bidding on a new issue, the underwriter needs to understand current yields and prices so they can judge what competition the new issue will face when it’s offered to investors.
The underwriter acts as the “middleman” between the issuer and investors:
The underwriter’s job is to find terms that work for both sides, and market indexes help set realistic expectations.
Assume ABC Underwriters Company identifies the $100 million high school general obligation bond and wants to pursue it. Before participating in the competitive bid, ABC needs help distributing the bonds. Even large underwriters typically bring in other financial firms - most often broker-dealers - to help sell the bonds to the public. For very large offerings (hundreds of millions or billions of dollars), one firm usually can’t sell the entire issue on its own.
In this example, ABC Underwriters Company is the lead underwriter. The lead underwriter handles several key responsibilities:
Think of the underwriting syndicate as a group of financial firms working together to sell a new-issue security. Before inviting other firms to join, the lead underwriter prepares a syndicate letter, which sets the rules of the syndicate, including incentives and responsibilities.
A major part of the syndicate letter is the spread. The spread is the difference between:
For example, assume ABC Underwriters Company plans to bid a 5-point ($50) spread on each $1,000 par bond.
A $100 million offering contains 100,000 bonds with $1,000 par value each. If every bond is sold, the underwriting syndicate could earn $5 million in total spread ($50 × 100,000 bonds).
The syndicate letter also specifies how that $5 million is divided among syndicate participants by setting:
The management fee is paid to the lead underwriter for its management services. It’s typically the smallest portion of the spread. The lead underwriter structures the syndicate, recruits members, serves as the issuer’s main contact, manages syndicate finances, and coordinates the overall process. In this example, assume the management fee is $5 per bond.
The additional takedown is paid to each syndicate member (the firms, typically broker-dealers, that join the syndicate). Syndicate members take on liability in the underwriting. Remember: general obligation bonds are always sold on a firm basis, meaning any unsold bonds remain with the underwriting syndicate, not the issuer. The additional takedown compensates syndicate members for taking that risk. In this example, assume the additional takedown is $15 per bond.
The selling concession (typically the largest portion of the spread) is paid to the firm that actually sells the bonds to investors. Since the total spread is $50, and we’ve allocated $5 to the management fee and $15 to the additional takedown, the selling concession must be $30 per bond in this example.
Let’s summarize the $50 spread:
In many offerings, syndicate members do most of the selling. When a syndicate member sells a bond, it earns:
When a syndicate member earns both, it’s called the total takedown (additional takedown + selling concession). In this example, the total takedown is $45.
If a syndicate member can’t sell all the bonds it’s allotted, it may bring in another firm to help. These firms are called selling group members. Selling group members help distribute the bonds but do not take on liability. If bonds go unsold, selling group members aren’t stuck with them (syndicate members are). Because they don’t assume liability, selling group members don’t receive the additional takedown, but they may receive the selling concession.
The lead underwriter usually takes on some liability and may also sell bonds to its own customers. If the lead underwriter sells bonds directly to its customers, it earns the entire $50 spread (management fee + additional takedown + selling concession).
The syndicate letter sets the management fee, additional takedown, and selling concession. This matters because compensation drives participation: if the economics aren’t attractive, the lead underwriter may struggle to recruit firms into the syndicate.
The syndicate letter also defines how liability is shared among syndicate members. Even though the offering may be firm, liability within the syndicate can be structured in one of two ways: eastern or western.
An eastern syndicate is an undivided syndicate. All syndicate members share liability together, regardless of how many bonds each member sells.
In the $100 million high school bond example, there are 100,000 $1,000 par bonds. Assume five syndicate members each take 20% of the offering (20,000 bonds each). Sales results are:
Total leftover = 50,000 bonds
The syndicate sold only 50% of the bonds it purchased from the issuer, leaving 50,000 bonds in inventory. In an eastern syndicate, that leftover inventory becomes a shared problem. With the lead underwriter coordinating, the unsold bonds are redistributed based on original liability (20% each). With 50,000 bonds leftover, each syndicate member ends up with 10,000 unsold bonds:
That’s the key idea: even though SM1 sold its entire allotment, it still shares in the unsold inventory because liability is pooled.
Western syndicates are divided syndicates. Each syndicate member is responsible only for its own share.
Using the same assumptions and the same sales results:
Total leftover = 50,000 bonds
The syndicate still has 50,000 unsold bonds in inventory, but in a western syndicate the liability stays with the members who didn’t sell their full allotment:
Depending on the security and expected demand, the lead underwriter may choose either structure. If demand is uncertain, syndicate members may prefer an eastern syndicate so unsold bonds are spread across the group. If demand is strong, members may prefer a western syndicate, where strong sellers aren’t burdened by weaker sellers.
If demand for the new high school bond is high, sales priority becomes important. What if investors request more bonds than are available? The lead underwriter must set the priority order that determines which orders are filled first. Priorities can vary, but the typical order is:
You may remember the corporate new issue process, which involves SEC registration and a 20-day cooling-off period that restricts sales, advertising, and recommendations until the registration becomes effective. Municipal securities are exempt from registration, so they avoid this process entirely. Because of that exemption, syndicates can attempt to sell the bonds before winning the bid (there’s no cooling-off period for exempt securities).
If a financial representative at a syndicate member firm discusses the bond with an interested customer, the customer can place an order before the syndicate wins the bid. The customer won’t know final pricing details (such as the exact price and yield), but will know the issuer and the purpose of the financing (for example, building a new high school). These are pre-sale orders, and they receive first priority. Underwriting fees for pre-sale orders are shared across the entire syndicate.
If the syndicate wins the bid, it opens an order period - the timeframe (from less than an hour to a few days) during which the syndicate accepts orders for the new bonds. If demand is high, bonds are allocated according to the priority schedule.
After pre-sale orders, group net orders have the next priority. These are orders where underwriting fees are credited to the entire syndicate.
Some orders are credited directly to one or more specific syndicate members. These are designated orders, and they are third in priority.
You may wonder why some orders are credited to the group while others are credited to specific members. There are several reasons, and the exam generally doesn’t test them. What you do need to know is what each order type means (for example, group net profits are shared across the syndicate) and the typical priority order (pre-sale, group net, designated, member).
Some syndicate firms may also manage their own portfolios (for example, a municipal bond mutual fund). A syndicate member may want to buy some of the new bonds for its own investment account. These are member orders, and they have the lowest priority.
A commonly tested point is the order itself:
You can remember this as PGDM.
The main terms of the syndicate letter are now set (spread breakdown, liability structure, and order priority). Once the syndicate letter is complete, each syndicate member signs it, formally creating the syndicate. The lead underwriter then coordinates the discussion that determines the bid.
The syndicate wants to win the bid so it can purchase the bonds and resell them to investors at a higher price, earning the spread. The bid must be competitive enough to win, while still leaving enough compensation for the syndicate. Once the syndicate agrees on the bid, the lead underwriter completes the issuer’s bid form.
On the bid form, the underwriter specifies the reoffering yield, which is the yield investors will receive at the price offered by the underwriter. Setting these yields is called writing the scale, and it may look like this:
| Maturity | Coupon | Yield |
|---|---|---|
| 1/1/2025 | 4.0% | 3.2% |
| 1/1/2030 | 4.0% | 4.0% |
| 1/1/2035 | 4.0% | 4.4% |
| 1/1/2040 | 4.0% | 5.1% |
As you already know, price and yield move in opposite directions:
The reoffering yields affect the issuer’s borrowing cost. If investors demand higher yields, the city’s financing becomes more expensive. Because multiple syndicates will bid, the city can compare bids and select the lowest-cost option.
When the bid form is complete, the lead underwriter submits it along with a good faith deposit. The good faith deposit is the syndicate’s “ticket to play” and typically equals 1%-2% of the total issue. It shows the syndicate is serious about its bid.
If the $100 million high school bond requires a 2% good faith deposit, the syndicate submits a $2 million check with the bid form:
Issuers measure an underwriter’s cost using either net interest cost (NIC) or true interest cost (TIC). You don’t need to know the detailed calculations, but you do need to know this distinction:
The time value of money reflects the idea that a dollar today is worth more than a dollar in the future, largely because money can be invested to earn a return. For example, repaying a bond in 5 years generally costs less than repaying the same amount in 10 years because the issuer avoids additional years of interest payments. TIC reflects that timing effect; NIC does not.
Assume ABC Underwriters Company wins the bid. After the issuer receives the remaining amount owed (the total purchase price minus the good faith deposit), the bonds are owned by the syndicate.
As bonds are sold, proceeds are deposited into the syndicate account, which is managed by the lead underwriter. By law, the syndicate account must be settled within 30 calendar days of the syndicate receiving the bonds from the issuer.
At the end of the 30-day period, the lead underwriter determines which syndicate members are left with any unsold bonds, based on whether the syndicate is eastern or western.
For bonds that were sold, the syndicate must provide final confirmations to investors showing the price paid and the settlement date. These confirmations must be delivered on or before completion of the transaction (the settlement date).
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