Underwriting
As we’ve discussed in previous sections, 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 the unique process of underwriting a municipal security.
Let’s continue with our example in the previous section where a city was looking to raise $100 million to build a new high school. This time, we’ll cover the perspective of the underwriter. You already know about the Bond Buyer, which is an online publication primarily read by underwriters looking for potential business. When a company like Bank of America (which is the largest municipal underwriter) is looking for underwriting business, they’ll take a look at the Bond Buyer.
Underwriters search for municipalities selling bonds they feel are marketable to their own customers. When an underwriter sees the Official Notice of Sale for the $100 million high school bond, several underwriters could be interested. Before placing a bid for the bond issue, the underwriter will probably check on market statistics.
The Bond Buyer publishes several indexes and a yield curve relating to municipal bonds. The S&P 500 is an index that tracks the stock values of 500 large domestically traded equity securities. Bond indexes do the same thing, except they focus on bonds and track yield instead of prices. The municipal bond indexes and yield curve included in the Bond Buyer are:
Revdex (25 bond index)
- Tracks 25 revenue bonds rated A or better
- Published weekly
Bond Buyer index (40 bond index)
- Tracks 40 municipal (G.O. and revenue) bonds rated A or better
- Published daily
Bond Buyer 20 (20 bond index)
- Tracks 20 G.O. bonds rated A or better
- Published weekly
Bond Buyer 11 (11 bond index)
- Tracks 11 G.O. bonds rated AA or better
- Published weekly
SIFMA Index
- Tracks Variable Rate Demand Notes
- SIFMA = Securities Industry and Financial Markets Association
- Published weekly
Municipal Market Data (MMD) yield curve
- Yield curve of AAA-rated municipal bonds
These indexes provide underwriters with a picture of the municipal bond landscape. Prior to bidding on a new issue bond, it’s important to know the general dynamics of the market, including municipal bond yields and prices. This tells what competition the new issue bond faces when being sold. The underwriter is the “middleman” between the issuer and the investors. Investors want the highest rate of return, but the issuer wants to pay the least interest possible. It’s the job of the underwriter to find common ground, and the indexes that provide the competitive landscape for municipal securities help them find it.
Let’s assume ABC Underwriters Company finds the $100 million high school general obligation bond and wants to pursue it. Before taking part in the competitive bid, they need to find some help. Even the largest underwriters typically hire other financial firms, most likely broker-dealers, to help them sell the bond to the public. When bond issuances get into the hundreds of millions or billions of dollars, one financial firm cannot accomplish the task of selling the entire issue by itself.
In our example, ABC Underwriters Company is the lead underwriter, who performs several important tasks:
- Establish the spread breakdown
- Define liability for syndicate
- Set sales priorities
- Lead the bidding effort
- Manage and settle the offering
Establish the spread breakdown
You’ll want to think of the underwriting syndicate as the group of financial firms that work together to sell a new issue security. Before reaching out to other financial firms to form the syndicate, the lead underwriter will create the syndicate letter, which is a document that establishes the dynamics and incentives for the syndicate.
Part of the process involves establishing a spread. The spread is the difference between the price the underwriting syndicate pays for the bond offering versus the public offering price. For example, let’s assume ABC Underwriters Company wants to bid a 5-point ($50) spread on every $1,000 par bond they sell.
A $100 million bond offering will contain 100,000 $1,000 par bonds. Doing some quick math, the underwriting syndicate will potentially earn $5 million if every bond is sold. The syndicate letter will determine how the $5 million spread is split among the members of the syndicate by establishing the management fee, additional takedown, and selling concession.
The management fee is paid to the lead underwriter for their services. Typically the smallest portion of the spread, it compensates ABC Underwriters Company (the lead underwriter in our example) for their services, which relate mostly to management. The lead underwriter creates the structure of the syndicate, hires syndicate members, is the point of contact for the issuer, manages the syndicate’s finances, and handles unique challenges presented to the group. In this example, let’s assume the management fee is $5 for every bond sold.
The additional takedown is provided to every syndicate member, which are the financial firms (typically broker-dealers) hired by the lead underwriter. Syndicate members take on liability when taking part in an underwriting effort. Remember - general obligation bonds are always sold on a firm basis, which means any unsold bonds are stuck with the underwriting syndicate, not the issuer. This is a risk for the syndicate members, and the additional takedown compensates them for this risk. Let’s assume the additional takedown is $15 for every bond sold in this example.
The selling concession, which is typically the largest portion of the spread, is paid to whichever firm actually sells the bond. The most money is allocated to the firm that closes the sale, which is the most important part of the job. With the management fee at $5 per bond and the additional takedown at $15 per bond, the only other piece of the spread ($50) is the selling concession, which must be $30 in our example.
Let’s quickly summarize the breakdown of the $50 spread:
- Management fee = $5
- Additional takedown = $15
- Selling concession = $30
In many cases, syndicate members do the majority of the selling. When a syndicate member sells a bond, they earn two forms of compensation: the additional takedown (for liability) and the selling concession (for selling the bond). When a syndicate member earns both, it’s referred to as the total takedown (additional takedown and selling concession combined). In this example, the total takedown is $45.
If the syndicate member cannot sell the bonds they’re given by the lead underwriter, they can hire another financial firm to help them. Known as selling group members, these are firms that help the syndicate sell the new issue bond, but don’t take on any liability. If bonds go unsold, they are not stuck with them (but syndicate members are). Because of the lack of liability, selling group members are not eligible for the additional takedown, but they can receive the selling concession.
The lead underwriter usually takes on some liability and even sells the bond to their own customers. If they complete a sale to one of their own customers, the lead underwriter earns the entire $50 spread (management fee, additional takedown, and selling concession).
The amount of the management fee, additional takedown, and selling concession is established and set in the syndicate letter. This is one of the most important aspects of bringing financial firms into the syndicate. If the compensation is too small, the lead underwriter will have a tough time finding firms willing to participate.
Define liability for syndicate
The syndicate letter also establishes the liability of the syndicate. The offering may be firm, but liability can be enforced in one of two ways: eastern or western syndicates.
An eastern syndicate is known as an undivided syndicate. All of the syndicate members share liability together, regardless of how successful one syndicate member is. In our $100 million high school bond example, there are 100,000 $1,000 par bonds to sell. Let’s assume there are five syndicate members that all take 20% of the offering, which is 20,000 bonds each. The following occurs:
- SM1 sells all 20,000 bonds
- SM2 sells 10,000 bonds (10,000 leftover)
- SM3 sells 5,000 bonds (15,000 leftover)
- SM4 sells 15,000 bonds (5,000 leftover)
- SM5 sells no bonds (20,000 leftover)
Total leftover = 50,000 bonds
The syndicate members were only able to sell 50% of the bonds they purchased from the issuer. Obviously, this is a problem! The syndicate has 50,000 bonds that it couldn’t sell stuck in its inventory. An eastern syndicate makes this a problem for every syndicate member, regardless of their sales. With the coordination of the lead underwriter, the leftover bonds are now divided up according to the original liability (20% each). With 50,000 bonds leftover, each syndicate member will now be stuck with 10,000 bonds:
- SM1 stuck with 10,000 unsold bonds
- SM2 stuck with 10,000 unsold bonds
- SM3 stuck with 10,000 unsold bonds
- SM4 stuck with 10,000 unsold bonds
- SM5 stuck with 10,000 unsold bonds
This is how an eastern syndicate works. Some relate this to socialism, where liability is spread among the entire group, regardless of how well each syndicate member performed. Remember, syndicate member 1 (SM1) sold every bond they were given. However, they’re still stuck with 10,000 unsold bonds because the other syndicate members weren’t as successful.
Western syndicates, known as divided syndicates, avoid assigning blanket liability to every syndicate member. Instead, each syndicate member is directly responsible for their own share. Let’s again assume there are five syndicate members that all take 20% of the offering, which is 20,000 bonds each. The following occurs:
- SM1 sells all 20,000 bonds
- SM2 sells 10,000 bonds (10,000 leftover)
- SM3 sells 5,000 bonds (15,000 leftover)
- SM4 sells 15,000 bonds (5,000 leftover)
- SM5 sells no bonds (20,000 leftover)
Total leftover = 50,000 bonds
The syndicate has 50,000 bonds that it couldn’t sell stuck in its inventory. A western syndicate leaves the liability with the syndicate members that couldn’t sell their full allotment:
- SM1 sold out, no leftover bonds
- SM2 stuck with 10,000 unsold bonds
- SM3 stuck with 15,000 unsold bonds
- SM4 stuck with 5,000 unsold bonds
- SM5 stuck with 20,000 unsold bonds
If an eastern syndicate is like socialism, then a western syndicate is like capitalism. Every syndicate member’s benefits and liabilities directly relate back to their selling abilities. Syndicate member 1 (SM1) sold all of the bonds they were allocated and were left with no unsold bonds in their inventory, but syndicate member 5 (SM5) is stuck with all 20,000 bonds as they didn’t sell anything.
Depending on the dynamics of the syndicate and the characteristics of the security being sold, the lead underwriter may opt for an eastern or western style system. If syndicate members are concerned about the demand for a new issue bond, they may prefer an eastern syndicate, allowing the liability of unsold bonds to be spread across the group. If demand is not an issue, syndicate members may prefer a western syndicate, which directly benefits the firms that sell the most.
Set sales priorities
If there’s high demand for the new high school bond, the sales priority becomes especially important. What happens if investors request to purchase more bonds than what’s available? The lead underwriter is required to set the order of priorities that determines which investors get bonds. While the priorities can vary from syndicate to syndicate, we’ll discuss the typical setup:
- Pre-sale
- Group net
- Designated
- Member
You may remember the corporate new issue process, which involves filing registration paperwork with the SEC and a 20-day cooling-off period that prohibits sales, advertisements, and recommendations of the new issue until its registration is effective. Municipal securities are exempt from registration and completely avoid this process. Because of the exemption, syndicates can attempt to sell the new bond prior to winning the bid (there is no cooling off period for exempt securities).
If a financial representative working for a syndicate member discusses the bond with an especially interested customer, they can place an order prior to the syndicate winning the bid. The customer would have to be very interested to participate, as they will not know the specifics of the bond’s return (like price and yield), but they will be aware of the issuer (the municipality) and what the bond supports (a new high school, etc.). These are known as pre-sale orders, which are given first priority. Underwriting fees for pre-sale orders are equally shared across the entire syndicate.
If the syndicate wins the bid, they will then open an order period, which is the general timeframe (anywhere from less than an hour to a few days) where the syndicate seeks investors and accepts orders for the new bond. If the issue is in high demand, the syndicate will allocate the bonds in a specific order.
After the pre-sale, group net orders are given the next priority. These are orders taken by the syndicate where underwriting fees are credited across the entire syndicate. Some orders will be credited directly to one or a few syndicate members, and these are known as designated orders. These come third on the priority scale.
You may be wondering why certain orders are credited to the group versus specific syndicate members. There are a variety of reasons for this, which the exam generally does not cover. You will need to know the basics of each order (for example, group net order profits are provided to the entire syndicate) and the typical priority of each order (pre-sale, group net, designated, member).
Some of the financial firms in the syndicate may manage their own portfolios (for example, a municipal bond mutual fund). If this is the case, a syndicate member may be interested in buying some of the new bonds for their own investment purposes. These are known as member orders, which are the last priority.
One of the most tested concepts on the order priority is the typical order itself:
- Pre-sale
- Group net
- Designated
- Member
You can easily remember the order by memorizing the acronym PGDM. You can probably come up with a “cute” acronym to remember PGDM, but if you’ve ever seen Jurassic Park, it’s a pretty good dinosaur movie!
Lead the bidding effort
The main parts of the syndicate letter have now been established (spread breakdown, liability structure, and order priority). Once the syndicate letter is complete, the lead underwriter has each participating syndicate member sign it, which formally establishes the syndicate. At this point, the lead underwriter will facilitate a discussion that leads to the bid the syndicate places.
The syndicate obviously wants to win the bid so they can buy the bond and sell it to their customers at a higher price, making a profit. They’ll want to keep the cost of their services low enough to win the bid over other syndicates, but high enough to make a reasonable profit. Once the syndicate comes to an agreement on the bid, the lead underwriter will fill out the issuer’s bid form.
On the bid form, the underwriter specifies the reoffering yield, which is the yield investors will obtain at the price offered by the underwriter. This process is known as writing the scale, and will look something 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, the price of a security directly affects its yield. The higher the price, the lower the yield (and vice versa). Establishing the reoffering yields directly relates to how expensive the loan will be for the city. If investors demand higher yields from their bonds, the city must borrow more money. Thankfully, there will be several syndicates bidding on the bond, and the city will hire the cheapest option.
When the bid form is complete, the lead underwriter submits it along with a good faith deposit to the issuer. The good faith deposit is the syndicate’s “ticket to play” that typically represents 1%-2% of the overall issue. The good faith deposit ensures the syndicate is serious about its offer (like a security deposit). If the $100 million high school bond had a 2% good faith deposit requirement, the syndicate would include a $2 million check with their bid form. If they lose the bid, the check is returned. If they win the bid, the issuer keeps the check and the syndicate owes the issuer the difference.
Issuers measure the cost of an underwriter either through net interest cost (NIC) or true interest cost (TIC). You won’t need to know the specifics or the factors leading to calculating either cost measure, but it’s important to know TIC factors in the time value of money, while NIC does not. The time value of money relates to the idea that a dollar today is worth more than a dollar in the future. Time influences the value of money mainly due to opportunity. If the municipality pays off the bond in 5 years, the cost of the loan is less than if they repaid the same amount in 10 years due to the time value of money. By avoiding 5 years of interest payments, the issuer can take the saved money and invest it, making additional money. TIC takes this into consideration, while NIC does not.
Manage and settle the offering
Let’s assume ABC Underwriters Company wins the bid. Once the issuer is paid the difference between the good faith deposit and the overall amount owed, the bonds are now owned by the syndicate. When a bond is sold, proceeds from the offering are placed in the syndicate account, which is managed by the lead underwriter. By law, the syndicate account must be settled within 30 calendar days of receiving the bonds from the issuer.
At the end of the 30-day period, hopefully, every bond has been sold. If not, the lead underwriter finalizes which syndicate members are stuck with unsold bonds, depending on whether it’s an eastern or western syndicate.
For the bonds that were sold, the syndicate must provide final confirmations to investors that include the price paid and settlement date. These confirmations must be delivered on or before the completion of the transaction, also known as the settlement date.
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